Europe's Debt Crisis: Long-Term Economic Decline?

It is certainly true that, in the past few weeks, markets have focused on the weaker member states of the eurozone.

For a true global perspective, though, here is a discomforting thought: When it comes to budget balances, even the stronger euro members are less favorably positioned than most Asian countries to weather the turbulence.

In the 2010 projections, the budget deficit, as a share of GDP, of Greece, Ireland, Portugal and Spain varies from around -7.5% to more than -12%. In Germany, Europe's strongest economy, the deficit is "only" -4.7%.

In Asia, that would rank Europe's largest economy between Thailand (-5.2%) — which has been swept by violent turmoil — and the Philippines (-4.2%), which has fallen behind most southeast Asian nations in terms of GDP per capita.

The simple fact remains that, in the baseline scenarios, public debt as a percentage of GDP will soar, even in Europe's anchor economies. In the absence of gradual and not-so-gradual adjustments, it will climb to almost 200% in the UK and France — and to some 150% in Germany and Italy by the year 2020. Historical experience indicates that as the debt ratio exceeds 90%, it will tax economic growth.

Unfortunately, the eurozone is no longer soundly positioned. Rather, the European anchors are adrift.

Europe’s structural decline

More importantly, the economic erosion of the eurozone is not just a cyclical phenomenon, but an integral part of a structural transformation. In the foreseeable future, the drivers of growth — demographics, capital stock, as well as technological progress and productivity — increasingly favor developing countries.

According to the UN, the global population will amount to 9.2 billion in 2050, from the current 6.8 billion. Concurrently, the labor force will expand by some 1.3 billion, with most of the increase from Asia and Africa. In Europe, however, the working-age population will decrease by over 110 million people.

Furthermore, the dependency ratio — the number of people not in the labor force compared to those who are — will dramatically increase in developed regions, particularly in Europe. By 2050, the UN expects the dependency ratio to be around 54 in Asia, but about 74 in Europe — as a number of dependents per 100 persons of working age.

What about another key indicator of a prosperous economic future — a nation's capital stock? Historically, advanced economies have invested some 20% of their GDP in fixed capital formation per year.

In developing countries, the investment has been significantly more, peaking around 35-40%. Over the next four decades, the investment rates of China and India will be relatively high, at about 33-34% — or almost twice as high as in the leading European economies, the UK and Germany, per annum.

True, advanced economies will continue to dominate cutting-edge technological innovation, but several developing countries with rich pools of high-level human capital may also innovate at the frontier, as indicated by China's rapid advances in the cleantech sector.

Moreover, the potential for technological catch-up tends to be greater when productivity and per capita income are low, which is bound to support growth momentum in several developing countries.

According to most long-term projections, by 2050, the world's largest economies will include China, India and the United States. What is receiving far less attention is that Europe's share of G20 GDP will be more than halved from 25% in 2009 to about 10% in 2050. Such a vital decline of economic power will inevitably result in a concomitant decrease of political power.

Still, even if Europe's anchor economies can achieve 1.5% growth on average, Europe as a whole could remain among the largest economies. In order to sustain its leading position, however, Europe simply must become more cohesive as its growth slows.

According to European Commission President José Manuel Barroso, the major lesson learned from the Greek crisis is that monetary union is not possible without a political union of the European Union. It is precisely because of this that the future of the European Union will be determined in the coming months, not in 2050.

If Europe's leaders are able to implement the important structural reforms that can no longer be delayed, reinforce the stability pact and tighter financial regulations to curb speculation, the crisis has the potential to make a new, more economically powerful and thus politically cohesive Europe.

If, however, Europe fails or delays these changes, the crisis will substantially fragment Europe's political cohesion and further reduce its economic power.

Difficult choices ahead

Despite the economic size of Greece and its modest links with the eurozone, it is the perception that matters. If Athens is seen as a testing ground of the eurozone's rescue packages and structural reforms, investors may regard the Greek determination for structural change indicative of other eurozone economies.

In such circumstances, even Washington cannot avoid exposure. Over 50% of U.S. overseas assets are held in Europe. And the EU also represents some 20% of U.S. exports, which would be adversely affected by sluggish recovery in the eurozone. Similarly, Japan's lingering export-led growth is also vitally dependent on recovery in the United States and the eurozone.

The first test of change involves the ability and willingness of Greece to implement the tough austerity program. “This package has given us the time to make the major changes and reforms we need,” says Greek Prime Minister George Papandreou.

However, he has the support of only a slim majority of Greeks. And as the Greek government announced unpopular new cuts in salaries and pensions, thousands of protesters took to the streets of Athens and elsewhere in Greece in the fourth general strike this year, while three people were killed in a petrol bomb attack on a bank.

No "shock and awe" intervention — however bold or impressive — can save Greece, or other vulnerable economies in the eurozone, not to speak of safeguarding the euro, as long as difficult choices are deferred. Liquidity-based measures cannot address what are at heart solvency problems.
What investors look for is determined and speedy efforts to execute tough reforms in the eurozone.

The last thing they want to see is political hesitation and violent street demonstrations spreading from Athens to Lisbon, Madrid and eventually Rome, London and Frankfurt — and yes, even to the United States and Japanese metropolitan centers.