Europe needs to take a stand

Europe’s key challenge isn’t its common currency, says Jens Larsen, chief European economist and managing director for RBC Capital Markets.

Instead, “it’s the fact that in some areas, the euro-area economies are very closely integrated, but without the institutions necessary to manage it,” he told an audience of 160 on Tuesday, at an event presented in Calgary by the Economic Club of Canada.

Despite these concerns, Larsen remains optimistic. “While I wouldn’t call European policymakers nimble, they have taken big steps when under pressure,” he says.

In his speech, “Europe – What’s Next? Too Much Debt, Too Little Time,” the London-based economist emphasized several European countries — the PIGS — must enhance productivity and address high structural unemployment and debt.

“The good news is major reforms are underway; the bad news is in the short run it may lead to higher unemployment.”

Every country in Europe must balance its books. “To avoid a deep recession, countries that have been running current account surpluses – primarily Germany – must raise private-sector demand. German consumers have to loosen up, save a bit less and consume a bit more,” he says.

Further, Europe needs to underpin the funding and capital position of its banking system, and build more consumer confidence. “The problem is, the weaker sovereign nations are in no position to underpin their own banking systems – they may need help from the stronger European countries.”

Finally, “The ultimate step would be to create a full fiscal union with a strong central fiscal authority backing common issuance of European bonds.”

The Eurozone’s two flashpoints are Spain and Greece.

Read: Investors focus on Spain

“Things are looking bad for the Spanish government,” Larsen says, noting Spain must clean up its banking system and deal with the challenges that come with fiscal devolution. And the Spanish government must do a better job of communicating its intentions and establishing a credible plan.

But Spain’s difficulties pale in comparison to those of Greece, where the combination of a contracting economy and lack of fiscal control result in a dire outlook. “Greece needs debt restructuring, deep economic reform and much stronger institutions. It’s an attractive option for Greece to exit the euro area, but a false one.”

If Greece were to exit the eurozone, it would pose a major economic challenge for the rest of Europe. An exit from the euro would free the Greek economy from the shackles of stable money, and would instead deliver high inflation.

Read: Greece’s exit would be welcome

It would flatten Greece’s banking system, weaken its institutions, and alienate its foreign supporters – “all in all, not a good policy choice. Choosing that path would be extremely disorderly, both politically and economically. An orderly exit is an oxymoron.”

There are strong incentives to accommodate the country, the economist said, noting that would involve a form of restructuring of its debt, in return for economic and political reforms.