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Growing fractures threaten a fragile euro zone

From the U.S. to Japan, once crisis-stricken economies are stirring from their hibernation, and some observers expect Europe to soon follow suit – at least, if the monetary union doesn't tear itself apart first.

The euro zone's halting recovery appeared to hit another speed bump on Friday when the August reading of Germany's Ifo business climate fell 1.7 points to 106.3, the fourth monthly decline in a row. A 0.2-per-cent GDP decline in the second quarter and the Ukraine conflict rattled German nerves, but no one should get their lederhosen in a twist. Analysts remain generally sanguine, expecting 0.4-per-cent growth in the third quarter. The rest of Europe, however, keeps on teetering.

Mario Draghi's speech at Jackson Hole, Wyo., also Friday, reiterated that the European Central Bank stands ready to take further action to halt the periphery nations' possible slide into deflation. The ECB Governor added that "no amount of fiscal or monetary accommodation, however, can compensate for the necessary structural reforms in the euro area."

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Mr. Draghi in his speech applauded Spain for having adopted reforms to its labour market in 2012 (where "sectoral and regional collective bargaining agreements and wage indexation" were holding the economy back, he says), producing a year-over-year reduction in the unemployment rate from 26 per cent to 24.5. Even with these in place, the International Monetary Fund estimates that it will take until 2019 for the rate to dip below 20 per cent unless further measures are taken.

Mr. Draghi recommends that, rather than trying to compete with other countries for low-skill, low-wage jobs – a pointless exercise when workers will still have to be paid in euros – nations should place greater emphasis on education in order to develop high-skilled workers.

But where is the money for education supposed to come from? Spain's debt is a manageable but hardly encouraging 94 per cent of GDP, its economy has been growing at a snail's pace and it has just announced a series of tax cuts, which could further damage revenues. And it seems unlikely that voters will be able to stomach much more of this bitter medicine – further labour-market reforms will almost certainly stoke increasing unrest and frustration.

Some nations are seeing such instability already. After admitting on Aug. 20 that France would not make its deficit-reduction targets, François Hollande's ailing, unpopular government dissolved Monday in a cabinet reshuffle that saw its economy minister turfed. The current front-runner for the 2017 election is Marine Le Pen of the ultra-right-wing National Front party.

If France is wilting and few green shoots are to be seen in Spain, the rest of Europe's periphery is hanging lifeless over the rim of the flowerpot. Italy is back in recession for the third time, and is not expected to meet Europe's deficit-reduction targets either, nor is Portugal, which has just endured a high-profile bank failure. France, Portugal and Italy all posted either flat or declining inflation rates in July.

Even with its own economy apparently at risk, Germany's anti-stimulus (or as they would likely put it, "anti-debt monetization") stance remains the biggest obstacle to anything like the quantitative easing spearheaded by the Federal Reserve following the financial crisis. But starting in September, the Targeted Long-Term Refinancing Operation (TLTRO) will ease funding costs for periphery banks, which are significantly higher than for banks in the core countries. But you have to wonder whether the loans that periphery banks will be providing represent actual demand to fund increased business activity, or just the need to allow flailing companies to roll over their existing loans one more time.

Barring a bigger shock than the Ukraine crisis has delivered thus far, Germany and France will probably avoid deflation, even without ECB intervention. But the periphery is diverging once again, and proposing another four or five years of painful reforms would almost certainly spark major social disruptions. Unless Mr. Draghi makes good on plans to purchase asset-backed securities outright – which the Financial Times reports is mired in logistical problems – the calls for periphery countries to consider ditching the euro will only grow louder.

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