Europe's Recovery: Light at the End of the Tunnel?

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Alex Domanski / Reuters

Jean-Claude Trichet, president of the European Central Bank, arrives for the opening ceremony of the General Assembly in Frankfurt, Aug. 6, 2010.

Only three months ago, the euro zone seemed on the verge of implosion — markets hammered the region over mounting debts, and economic commentators discussed which euro-zone country would go bankrupt first. But as Europeans head off for their August holidays, they leave with a welcome sense of relief and optimism about the continent's economic situation.

Last week, the European Central Bank kept interest rates at record lows and said the economy in the third quarter was looking better than expected as rising demand for industrial products, overall optimism and declining German unemployment boosted the general mood.

In euro-zone powerhouse Germany, industrial orders jumped by 3.2% in June, more than twice the rate analysts had expected. Last month, the Economic Sentiment Indicator — which measures euro-zone confidence in the economic outlook — rose to the highest in more than two years. Meanwhile, the costs of insuring against countries defaulting are at a two-month low, bond spreads are tightening, and the cost of borrowing for governments is falling.

To those who portended its demise, the euro zone's turnaround has been astonishing. Even last month, Dutch bank ING issued a report, "Quantifying the Unthinkable," warning that a full-fledged disintegration of the euro zone would trigger the worst economic crisis in modern history. Such talk now seems banished.

"I'm surprised by how rapidly the euro zone has stabilized," says Karel Lannoo, CEO at the Centre for European Policy Studies, a Brussels-based think tank. "In May, I was very pessimistic about the euro zone. But the debt crisis was a wake-up call to policymakers to put the house in order, and they have done a lot to deal with it."

In May, the E.U. and the International Monetary Fund (IMF) agreed on a $1 trillion rescue package for euro-zone countries that run into dire financial straits. At the same time, key E.U. members, including Greece and other vulnerable Mediterranean countries, began austerity programs to restore their fiscal health and reassure markets. And last month, the E.U. conducted stress tests on banks, which seem to have done the trick of convincing markets that Europe's financial institutions are not hiding billions of euros of toxic debts.

The tentative optimism in Europe contrasts with the news from the U. S., where there is mounting evidence that the already sluggish recovery has lost momentum. U.S. economic growth slowed to an annualized 2.4% in the second quarter of the year, barely enough to support new job creation. Last week, the Labor Department reported that the number of people out of work rose by 131,000 in July. At the same time, the U.S. Federal Reserve also hinted it was prepared to print more money to support a faltering economic recovery if necessary. America's loss may be Europe's gain, as investors return to Europe seeking — of all things — stability.

Who remembers that three months ago there were heady predictions of dollar parity with the euro? In May, the euro hit $1.215, a four-year low against the dollar. It had already dropped 16% since the start of the year, and was still considered overvalued: analysts at UBS predicted it would fall to $1.10 by the end of the year. Yet on Monday, the euro was at $1.33, while the dollar itself was sliding, falling to a 15-year low against the yen.

However, the E.U. still faces challenges. While growth is back, it is uneven. Germany is surging, but in Greece and Spain, output is flatlining, growth prospects are dim and their economies need more than budget cuts to improve overall competitiveness. Many governments are likely to face serious social tension as their austerity programs start to bite. Last month, while praising European leaders for their quick response to the debt crisis, the IMF warned that "underlying problems" with how Europe monitors its economies have yet to be resolved, and it urged governments to keep a more watchful eye on their budgets. Many economists predict that Greece will default on its debt, even if the default comes a few years down the line.

"We should not feel relaxed," says Joachim Scheide, head of the Forecasting Center at the Kiel Institute for the World Economy in Germany. "The crisis is not yet over. The outlook is good, but it is concentrated on Germany. The E.U. as a whole will probably feel a deceleration of growth as the overall world economy slows."

The sovereign debt crisis has exposed how complacency has long been a problem for Europe, especially when it comes to economic policymaking. But for now, European leaders can enjoy their summer break, content that the existential threats that appeared to be eating at the euro zone just a few short months ago have retreated.