Euro Zone Returns to Growth, but Malaise Lingers

Updated August 14, 2013, 7:52 p.m. ET

Currency Area Emerges From Longest Postwar Economic Contraction

By MARCUS WALKER in Berlin and CHARLES FORELLE in LondonCONNECT

The euro zone's marathon recession has ended, spurred by solid economic performances in both Germany and France. But the modest recovery won't go very far in fixing the bloc's deeper problems and threatens to stoke a sense of complacency in European capitals.

The currency bloc's return to slow growth—confirmed by data published Wednesday that showed its economy grew at a 1.1% annualized rate in the second quarter—is likely to encourage European politicians to claim that the region's debt crisis is receding. Once-frantic efforts to fix the common currency's flaws are already showing signs of petering out.

Most economists say the recovery is too sluggish to overcome the euro zone's multiple ailments, including still-rising debts, mass unemployment, hobbled banks and political instability.

"A plus sign is always good, but it doesn't necessarily fix anything," said Adam Posen, president of the Peterson Institute for International Economics in Washington. "The big problem is the damage being done to the legitimacy of governments, to the productive capacity of Europe through forgone investment and to the supply of labor" through prolonged joblessness, including among the young.

Gross domestic product in the 17-country euro zone rose by 0.3% in the second quarter compared with the first, ending a sequence of six quarters of contraction. The improvement was led by quarterly growth of 0.7% in Germany and a better-than-expected 0.5% in France.

Germany bounced back strongly from a winter when lots of snow froze construction and an uncertain global outlook held back industry. France's consumers and government spent more freely in the three months to June. Analysts expect more growth ahead, but at a slower pace.

The depressed economies of Spain, Italy and Greece contracted again, but more slowly than previously. Portugal—one of five euro members with a bailout program—even grew by a surprising 1.1% last quarter, although its statistics office cautioned that the relatively early Easter holiday this year was partly responsible.

Ever since the European Central Bank ended the panic in euro-zone government bond markets a year ago by pledging large-scale bond-buying, the focus of Europe's crisis has shifted to the economic fallout, including rising joblessness, a lack of credit for business and the frayed social fabric. The euro has looked increasingly likely to survive—but at a high and lasting cost to Europeans' prosperity.

Growth of 0.3% per quarter won't change that, even if it is sustained.

"If we had three or four years of growth at 2% to 3% annually, then we would probably get out of the woods, because strong growth is forgiving of past mistakes," said Charles Wyplosz, economics professor at the Graduate Institute, Geneva. "But I don't know where such growth would be coming from."

Kasper Rorsted, chief executive of the soaps-to-adhesives conglomerate Henkel AG in Germany, said he thinks it will be years before Europe achieves a meaningful comeback because of chronic unemployment and other legacies of the crisis. "Our assumption is Europe will be in very sluggish growth if at all for the next three or four years," Mr. Rorsted said.

Indeed, it is hard to see how Europe's economy can reach escape velocity. Among the brakes on the recovery: continuing budget austerity, lack of affordable bank loans, rising unemployment and weak household incomes, and lack of investment by companies that are still operating well-below capacity.

The euro-zone economy is still 3% smaller than in early 2008, when the global financial crisis was beginning to hit hard. In many countries, far more businesses are failing than being founded, and firing rather than hiring.

Annualized growth of 1.1% is considered too slow to bring down an unemployment rate that has reached a euro-era record of 12.1%. Productivity tends to improve by around 1% a year when Europe isn't in recession, meaning companies can produce more without hiring. Markedly faster growth is usually needed to boost demand for labor.

If unemployment stays high, it will keep hurting consumer spending, company sales, government budgets and bank loan quality. Mr. Wyplosz said the biggest danger now is that bank asset quality continues to worsen, preventing a revival of lending to business and of investment and hiring. The weakness of many European banks could still pile severe fiscal pressure on governments that have to prop them up, he said.

Among the good news: The economic meltdown in Southern Europe is slowing considerably.

But it has left the economies of Italy, Spain, Greece and Portugal deeply deflated, so that their governments' solvency—reflected in the ratios of public debt to gross domestic product—will continue to worsen, despite strenuous austerity efforts.

A toxic mix of lost economic output and budget deficits is set to push Spain's national debt—only 36% of GDP in 2007—to over 100% by 2015, according to the International Monetary Fund. Italian debt is on course for over 130% of GDP this year, according to the European Union.

The euro zone's giant banking sector, which ballooned before the crisis, now needs to shrink. Stingy lending will smother Europe's economy for years, just as easy credit greased it earlier.

"Europe is already more than halfway to a lost decade," said Barry Eichengreen, economist at the University of California, Berkeley.

Mr. Eichengreen co-wrote a recent study comparing the euro zone's current path with earlier international debt crises. The finding: Five years into its downturn, the euro zone resembles Latin America's "lost decade" in the 1980s more than East Asia's rapid rebound from its 1997 crash.

Latin America also had a weak recovery mid-decade, but the crisis passed only after comprehensive debt restructurings around the end of the decade.

In Europe, Portugal will need a debt restructuring and Greece—which already had one—will need more, Mr. Eichengreen said.

Spain and Italy might too, he said, unless their GDP grows "at a much faster rate."

Write to Marcus Walker at marcus.walker@wsj.com and Charles Forelle at charles.forelle@wsj.com

A version of this article appeared August 15, 2013, on page A1 in the U.S. edition of The Wall Street Journal, with the headline: Europe's Economy Starts To Grow.