Eurozone Leaders Can No Longer ‘Kick the Can Down the Road’
Although the formation of a new government in Greece has gone some way to avert concerns about the break-up of the Eurozone, the summer Ernst & Young Eurozone Forecast (EEF) highlights how the health of the European economy is likely to get worse over the next six months before it has, at best, an anemic recovery in 2013. And there are plenty of down-side risks to the forecast especially if Eurozone politicians do not agree a suitable way forward starting this week at the summit of EU leaders in Brussels.
Mark Otty, Ernst & Young Area Managing Partner for Europe, Middle East, India and Africa comments, “Any kind of recovery is dependent on Eurozone political and financial leaders seizing the initiative over the next few weeks to head off the pressing problems in Spain, Italy and Greece. Flexibility and real leadership are required to move the agenda on rather than simply “kicking the can down the road”. The difficult balance between growth and austerity has to be found with neither option at the exclusion of the other.”
The forecast assumes that the Greek austerity program will proceed and that other Eurozone members such as Spain and Italy avoid further serious financial turbulence. If this happens some of the current risk aversion among financial markets, businesses and households will start to lift towards the end of 2012 although output in the Eurozone as a whole is forecast to contract by 0.6% this year. Any recovery in 2013 will be modest given the multiple headwinds facing the Eurozone with growth of 0.4% expected.
As the pace of fiscal tightening starts to ease in 2014 and the world economy gathers pace, EEF forecasts that the Eurozone will post growth of 1.7% in 2014, and 2% in 2015 and 2016.
Growth is far from consistent across the region highlighted by an ever widening gap between the core, mainly Northern, countries in the Eurozone and their southern neighbors. Since the EEF first highlighted this increasing divergence in economic performance 18 months ago this disparity has accelerated. While some core Eurozone countries will avoid recession this year and post reasonable growth next year, the EEF is forecasting that no growth will return in the periphery countries until 2014. And the high unemployment levels in the peripheral countries, particularly among the young, is now at levels that could potentially threaten the stability of society.
Marie Diron, senior economic adviser to the Ernst & Young Eurozone Forecast comments, “The financial and political leaders of the Eurozone have to now take the lead in a more determined and focused way than they have so far been willing to do in the last two years. The time for debate is over and the need for action starting at the EU summit today is becoming ever more pressing.”
Greece remains in Eurozone
The recent Greek elections delivered a working coalition of parties in favor of the IMF/EU program. Yet it also gave the parties opposing the bailout a sizeable vote and there remains a significant risk that the challenges to implementing the fiscal and reform measures in Greece become too great, resulting in an eventual exit from the Eurozone. Although the risk of a break-up has intensified in recent months, EEF continues to assume that the Eurozone remains intact in its current structure.
Marie comments, “For the Eurozone, a failure to save Greece would undermine market confidence in its ability to save others, and lead to further capital flight from countries such as Spain, Italy and Portugal. In itself this could lead to further departures and a collapse of the single currency, with devastating economic and social impacts.”
Deep and prolonged restructuring
The second long-term refinancing operation (LTRO) by the European Central Bank (ECB) provided some welcome relief that reduced the risk of an imminent credit crunch. Banks reported that the credit standards they demanded of potential borrowers had steadied, while banks’ own liquidity positions and access to finance seemed to have stabilised after a sharp worsening during 2011.
Yet the demand for loans was significantly weaker at the start of Q2 2012 so while the credit crunch has been averted this has done little to encourage corporate or consumer appetite for borrowing.
Marie explains, “Although the likelihood of a credit crunch in the immediate future has been avoided for the time being the Eurozone banking sector still needs to go through a deep and prolonged restructuring that will curtail availability of credit for some time.”
The ongoing divergence in economic performance around the Eurozone has continued to widen differentials in labour markets. The jobless rate has risen to almost 25% in Spain, 22% in Greece, and 15% in Portugal, an increase of between three and four percent in each market over the last six months. This has further undermined domestic demand and investment and the ability of governments to deliver fiscal deficit reduction plans. Meanwhile in Germany, Austria and the Netherlands, unemployment remains below 6%.
The deteriorating job market, low wage growth and uncertainty around the future of the single currency are all weighing on consumer confidence. With the exception of Germany, where households are reasonably upbeat according to recent surveys, consumer confidence across the Eurozone has continued to deteriorate in recent months.
As a result EEF predicts that real consumer spending will grow by around 0.9% in Germany in 2012, by just 0.2% in France and to stagnate or fall in much of the rest of the Eurozone. As uncertainty around the Eurozone’s structure dissipates moving into 2013 EEF expects consumer spending to regain momentum in the ‘core’, growing by 1%. However, household spending in the periphery is likely to fall further in 2013 and only bottom out in 2014.
Growth vs. Austerity
Against this gloomy and risk-laden background the policy debate has begun to focus on how to deliver faster growth, without which austerity programmes may ultimately prove self-defeating.
Marie comments, “For some the debate between austerity and growth is a straight choice, but this is a dangerous simplification. Given the exposure of banks around the Eurozone to sovereign debt, fiscal stability and the stability of the financial system are more deeply interconnected than ever. Therefore fiscal stability is a key part of a return to health in the banking sector, and the provision of finance for investment and growth.”
Elements of fiscal policy can be adjusted in a growth-friendly manner. The composition of government spending can be changed at the national level to spur growth shifting from current to capital expenditure. Those parts of the Eurozone that are more fiscally sound could relax their consolidation plans in order to boost domestic demand, helping spur activity elsewhere.
A second key component of a growth strategy has to be broadening trade with rapid-growth markets – Germany is already enjoying substantial growth in its capital goods exports to China and elsewhere, but other countries do not. The challenge is for Italy, Spain and others to follow. In order to secure ongoing competitiveness in the EU periphery Germany in particular may need to accept higher wage and price inflation domestically. As a short-term solution, this stance is finding traction among German policy makers, but how durable this will be is uncertain.
Difficult year(s) ahead
Although the forecast assumes that the Eurozone will remain intact with the new Greek government recommitting to the IMF/EU deal and the pressures on Spain and Italy subsiding, it will be a difficult year ahead. Without a recovery in consumer and business confidence and the spectre of high unemployment ever present it remains a bleak outlook.
Marie concludes, “Although we expect the Eurozone to remain intact, the risks of a break-up have intensified over the past quarter. As such there is a shared interest in not just keeping the financial crisis at bay, but also generating a sustainable return to growth around the Eurozone. This shift in focus is welcomed but it has to be underpinned by an ongoing commitment to fiscal discipline. It will also require difficult decisions to be taken in all economies, not just in those where the crisis is worst.”
Mark concludes, “As important as it is to fix the short term problems of the Eurozone, policy makers must not lose sight of the more fundamental longer term problems. Even when this period of uncertainty is finished and some sort of stability returns, Europeans will have to take a long hard look at their economic future. Productivity in much of Europe lags well behind other parts of the world and working practices are often outmoded. This combined with an ageing population poses some serious questions.
“The Eurozone stands at a critical point for its future survival and success. It needs creative thinking, flexibility, a clear message and an understanding from its leaders that they have to take their people with them.”