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the flash GDP growth estimates for the first quarter of 2013: euro-area GDP is down by 0.2% compared with the previous quarter and 1% down compared with the same quarter of last year. Even German GDP fell by 0.3% compared with the same quarter of last year. European developments are in sharp contrast to the US, where annual growth was 1.8% in the first quarter of 2013 and where productivity is increasing, business investment has returned, credit is on the rise, and private consumption is increasing – after a major deleveraging of the household sector.

Europe’s response to the growth problem consists of structural reforms to boost the long-term growth potential and fiscal consolidation to restore trust and fiscal sustainability. Also, key targets, at least in words, are the restoration of a healthy financial system and some largely symbolic initiatives to address demand shortage problems, such as the faster use of structural funds, more investments by European Investment Bank, and the issuance of project bonds. But even President Barosso acknowledged two months ago that the implementation of last year’s Compact for Growth and Jobs “”. In fact, Europe’s response to the short-term growth problem has been extremely weak.

Europe has a well-known long-term growth problem (see our recent policy brief), but there is a major risk that short-term troubles will damage further the long-term growth potential, for six main reasons.

First, persistently high unemployment is eroding skills, discouraging labour market participation, thereby undermining the long-term growth potential. Youth unemployment, which is at record high in a number of countries, is especially alarming as a long period of unemployment after graduation, when a worker should acquire the first working skills, can undermine the whole career of a worker. EU leaders promised to act decisively against unemployment, yet no result is seen so far.

Second, business research and development (R&D) activities are rather pro-cyclical, ie firms spend much less on these activities in an economic downturn, especially when the timing of recovery is seen remote. But a long period of withheld R&D reduces the efficiency of companies. Since 2007, total factor productivity is sinking in most of Europe. At a lower efficiency, the growth of supply can be slower when demand returns.

Third, weak economic growth and weak bank balance sheet are mutually reinforcing each other, with negative implications for long-term growth. A weak economy leads to bank losses, thereby deteriorating bank balance sheets. Banks with weak balance sheet tend to roll-over the dubious loans of their existing clients, instead of realising further losses (a process frequently called “zombificaion”), and do not grant credit to young and innovative firms. Thereby, struggling firms that do not generate much growth are kept alive, but new and more productive firms are unable to grow. Similar developments characterised Japan in the 1990ies that has led to a lost decade. Europe committed to shore-up banks, but policies so far was clearly inferior to the US, where bank restructuring was largely completed by 2009.

Fourth, before the crisis, household and corporate debt increased substantially and reached too-high levels in a number of EU countries. But private debt deleveraging has been much slower in Europe than in the US since the crisis. History shows that deleveraging episodes can be protracted and can act as a drag on growth. Economic stagnation in the short run makes it more difficult for the private sector to deleverage and thereby can protract the period of deleveraging and undermine growth in the medium term.

Fifth, stagnation in Europe undermines the attractiveness of Europe for investment. When investment moves to other locations instead of Europe, the long-run growth potential of Europe is weakened.

And sixth, a protracted period of weak growth and high unemployment are undermining the EU citizens’ trust in the ability of EU institutions to provide useful policy advice. Thereby, it weakens domestic commitments to vitally important but painful structural reforms, which are also fostered by EU institutions. Backtracking on structural reforms would weaken the long-term growth potential.

After the so many disappointing growth and unemployment figures, a comprehensive effort is needed to revive growth in Europe. Otherwise, Europe may follow a Japanese-style lost decade. The top priority is to fix banks now, ie in 2013. Measures supporting lending, including lending to small and medium sized enterprises, are needed. Secondly, various measures for investment and innovation should be sought. The EIB needs much more additional capital than the €10 billion agreed last year and the internal procedures of the EIB should be revived to allow for much faster investments. Thirdly, the problem of private demand shortage should be addressed and fiscal strategies should be adapted to the economic situation. While in the highly-indebted southern European countries a gradual fiscal consolidation has to continue, there is a case for a new direction for fiscal policy in northern European countries. Fourth, the major imbalances inside the euro area have to be reversed, which cannot be achieved at a low inflation: the ECB should ensure that inflation does not fall below the two percent target, and countries in northern Europe should refrain from domestic policy actions that would prevent inflation from rising above two percent.