The European economy appears to finally beemerging out of the long tunnel of stagnation. The eu-rozone’s real GDP, after contracting for six consecu-tive quarters from the October–December quarter in2011, rose on a quarter-on-quarter basis in the April–June quarter last year, and went on to post positivegrowth for three consecutive quarters until the Octo-ber–December quarter, albeit at more modest levelsaround an annualized rate of 1%.

Looking back, Europe has been focusing on fiscalreconstruction during the sovereign debt crisis, whichstarted with revelations of Greece’s window dressingof its fiscal deficit in October 2009, and it has beenfacing deflationary pressure associated with the cri-sis. If the European economy is truly recovering, Eu-rope will join the United States and Japan in drivingthe global economy, which is definitely very goodnews for the global economy.

Our conclusion, however, is that it could be tooearly to adopt that optimistic view. This is because,given a lack of demand, deflationary pressure is infact increasing. As a result, non-performing loans atfinancial institutions continues to rise, and the risk ofa financial system crisis occurring has not been re-duced at all.

The chart shows trends in the GDP gap ratio inthe eurozone, and outstanding non-performing loansand the non-performing loan ratio in the five mostheavily indebted countries (Portugal, Italy, Ireland,Greece, and Spain) from 2009. The first thing that at-tracts attention is that the GDP gap ratio shrank from2009, hit a peak of �0.764% in 2011, and then wors-ened to �2.749% in 2013, roughly the same as thelevel in 2009 in the immediate wake of the Lehman cri-sis. In fact, although real GDP rose in the October–De-

cember quarter last year on a quarter-on-quarter basis,the rise reflected an increase in foreign demand, andthe contribution of domestic demand declined. As theeffects of fiscal stimulus after the Lehman crisis de-clined, fiscal policy changed to fiscal tightening withthe emergence of the sovereign debt crisis. However,private-sector demand has not recovered sufficiently tooffset the effect of deflationary pressure. This is shownby the high unemployment rate of the eurozone, whichremains at a record level of 12%.

The second point is that non-performing loanshave increased dramatically. Outstanding non-per-forming loans in the heavily indebted countries are es-timated to have doubled from around 390 billion eurosin 2009 to approximately 780 billion euros in 2012. Thenon-performing loan ratio is estimated to have risenfrom 6.4% in 2009 to 14.1% (for countries excludingItaly). The non-performing loan ratio is far higher thanthe peak seen in Japan, 8.9% in 2002, during its ownfinancial crisis, and suggests a heavy burden on the fi-nancial institution management in Europe.

History tells us that a sovereign debt crisis willtransform into a financial system crisis, which ulti-mately will transform into a burden on taxpayers. Eu-rope is standing at the gateway to a financial systemcrisis. In the event financial institutions begin to col-lapse in a chain reaction, the entire economy will in-evitably enter a deflationary spiral. The EuropeanUnion is not just standing idly by, and responding tothe risk described above, it is striving to rapidly de-velop a single resolution mechanism for bank failures.However, with non-performing loans of 370 billioneuros, for which no reserves have been set aside in thefive most heavily indebted countries, it is reasonableto question whether a planned single resolution fundof 55 billion euros is adequate.

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European Economic Outlook: No Room for Optimism

Government bond yields in the heavily indebtedcountries, after surging to dangerously high levels,have stabilized thanks chiefly to ECB President MarioDraghi’s announcement of an unlimited governmentbond-buying program in September 2012. The debtcrisis appears to have eased. Monetary policy may

control the market, but its effects on improvements inthe real economy are limited. Since Europe has chosento strengthen fiscal discipline, it will logically have topay the price in the real economy. Europe may thushave to be prepared for deflation for some time tocome.

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