Eurozone: Back to black

Eurozone: Back to black

Eurozone: Back to black

Global Economic Outlook Q3 2012

Economic news from the Eurozone suggests that the euro crisis is probably deeper than ever. A combination of economic and political issues is threatening the viability of the Eurozone.

The glimmer of hope that the Eurozone’s crisis reached a positive turning point in the first quarter turned out to be all-too-faint as the region’s economic woes returned with full force in Q2. In fact, the crisis is probably more severe and deeper than ever, and it is threatening the viability of the Eurozone in its current form.

The reasons are political as well as economic. The rise of the radical left in Greece aroused new fears about a Greek exit from the Eurozone. The so-called “Grexit,” once considered unthinkable, has become a distinct possibility. However, the second round of Greek elections in June resulted in a pro-euro coalition. Meanwhile, the French presidential and parliamentary elections resulted in a socialist victory that is straining the Franco-German consensus on the handling of the euro crisis.

The situation in the financial markets worsened in the second quarter. Risk premiums for Italian and Spanish bonds increased, and concerns about the future of the Eurozone led to capital drains from periphery countries and greater insecurity about the Eurozone’s future. The Spanish banking sector will receive up to 100 billion euros to offset non-performing loans from the real estate bubble, making Spain the first big Eurozone country to apply for a European bailout. Whether or not the decisions taken at the European summit in late June will bring back the glimmer of hope in Q3 remains to be seen.

Eurozone outlook continues to be grim

Eurozone GDP stagnated in the first quarter of 2012 and was marginally (0.1 percent) below the level it achieved in the first quarter of 2011. The unemployment rate lingers at 11.2 percent, the highest unemployment rate in the history of the Eurozone. Looking behind the curtain of averages reveals persistently wide variation between the northern and southern Eurozone members (see figure 1). Austria’s 3.9 percent unemployment rate is the lowest in the Eurozone, and Spain’s is the highest. In fact, the Spanish unemployment rate is only very slightly below the U.S. unemployment rate at the height of the Great Depression in 1933 (24.9 percent).

Source: Eurostat

Figure 1: Unemployment rate

The Economic Sentiment Indicator (ESI) for the Eurozone, which includes confidence indicators from industry, services, and consumers, fell to 89.9 in June (see figure 2). The long-term average—and the threshold between a negative and a positive outlook—is 100. Confidence in industry and services fell in May and June. However, as a ray of hope, the retail trade indicator rebounded in June after a sharp fall in May. Consumer confidence fell slightly after an increase the month before. Interestingly, consumer expectations about their own financial situation improved in the Eurozone.

The economic climate in Germany is still slightly positive, according to the ESI, but it is declining. This is confirmed by the Germany-specific ZEW index. From May to June, it experienced the sharpest fall on a monthly basis in 14 years. While the index is a snapshot, its fall could signal that the euro crisis is starting to hit Germany.

Source: European Commission

Figure 2: Economic sentiment indicator

Solving the crisis: Economics meets EU politics

The renewed crisis has generated many ideas about how to solve it. The proposed solutions on a European level include fiscal union, the introduction of euro bonds, European deposit insurance, and a banking union. Yet, these proposals would require a much higher degree of integration than currently exists in Europe. What they have in common is that they imply substantial redistributions in terms of money and risk between northern and southern Eurozone countries to recreate the periphery’s access to funding. The economic rationale is that, as a whole, the Eurozone’s debt-to-GDP ratio is comparatively favorable. In fact, the Eurozone ran a budget deficit of 4.1 percent of GDP in 2011, which is less than half the size of the deficits in the UK and the United States. Therefore, the fragmented nature of European debt is one of the key problems (see figure 3).

While the economic logic is intuitive, any solution needs to consider the character of the European Union and its decision-making process. The European Union basically remains an association of nation-states with supra national characteristics and many veto points and actors. Realizing a true fiscal union on a European level, for instance, would require completely overhauling the EU’s character. It would require a harmonization of fiscal policies, and by implication, such harmonization would need to span very idiosyncratic European welfare states and tax systems. The associated loss of national sovereignty would be unprecedented in EU history. To be of any relevance for the current crisis, this quantum leap would need to be undertaken quickly.

Lessons from EU integration

Looking back at the development of the European Union reveals two lessons. First, comprehensive moves toward integration take time. Consider the most recent step toward integration, the Lisbon Treaty. The drafting of the EU’s constitutional treaty started in 2001, and it took three years to finish and sign it. It was then rejected in several national referenda, and a new treaty had to be developed. The Lisbon Treaty finally came into force at the end of 2009.

Second, there are different sorts of integration, and the European Union tends to favor one over the other. European integration theorists argue that European integration is biased toward negative integration. Negative integration is about market creation and removing barriers to free trade and competition. The single market was the major milestone in this regard. Positive integration—the harmonization and centralization of policies and regulations—has always been much harder. It often failed due to the very different public policies and governance structures of the member states as well as their diverging interests.

Source: Eurostat

Figure 3: Budget deficit 2011

A substantial jump in integration and the corresponding transfer of sovereignty to the European level would require consent on both an intergovernmental and a national level. It is quite likely that these decisions would need to be confirmed through referenda in some countries, while in others, it would become an electoral focal point. Whether or not the electorates in the creditor and debtor nations are in favor of a deeper political union or of higher inter-European redistribution is an open question. This uncertainty would be a drag on the financial markets and the credibility of plans about deeper integration.

Far-reaching plans for deeper integration and big-bang solutions will therefore face very substantial hurdles. It cannot be excluded that the depth of the current crisis could generate completely new patterns of integration. However, if history is any guide, the way out of the current crisis will likely be a step-by-step process. It will likely favor solutions that solve pressing problems over ones that require comprehensive institutional or systemic reforms.

Two certainties and a trade-off

There are two certainties about the Eurozone’s future. First, Eurozone countries need to deleverage and bring their fiscal houses in order because public debt has reached clearly unsustainable levels. Second, the Eurozone needs growth.

While these two certainties may go hand in hand in the medium and long term, they tend to be contradictory in the short term. Reducing state expenditure and, therefore, aggregate demand during a period of high unemployment and spare capacity does not help growth.

Worse, traditional economic stimulus is not viable. While the interest rate, which is currently at 0.75 percent, could be lowered, it is unlikely to have a significant effect. Liquidity is not the problem. Investors’ unwillingness to finance troubled Eurozone countries is at the heart of the crisis, so comprehensive deficit spending is also not a realistic option. Moreover, postponing fiscal consolidation is difficult because it would shatter the already-fragile confidence of the Eurozone’s investors.

Design of fiscal consolidation is crucial

Given that there is no alternative to fiscal consolidation, two components are crucial: timing and design. In terms of timing, a gradual approach to fiscal consolidation would benefit growth in crisis countries. However, it can only work with credible plans for medium-term consolidation. A more gradual approach requires a clear roadmap for deficit reduction. After all, investors want to be sure that they will be repaid at some point in the future. Thus, the prospects for the medium- and long-term fiscal sustainability and economic growth are crucial signals to investors and financial markets.

Source: Eurostat

Figure 4: Public spending on pensions and education, R&D expenditure 2010

Growth has a dual meaning. It refers to short-term growth in the business cycle as well as to the economy’s long-term growth potential. Bringing these two together to the largest degree possible should guide the design of fiscal consolidation. Three factors are critical in this regard:

  • Multiplier effect: In the short term, the multiplier effect of government spending is an important way to preserve growth. For example, money flowing to low-income households is likely to have a high multiplier effect as a large percentage of this money will be spent.
  • Composition of consolidation: The nature of fiscal adjustments—whether they focus on cutting public spending or increasing taxes—makes a difference for growth. Empirically, spending cuts are less damaging to economic growth than tax increases.
  • Investment versus consumption orientation: When it comes to public spending, structure is just as important as size. Public expenditure supports the economy’s growth potential most effectively with investments in education, infrastructure, and technology. Thus, a focus on these areas as opposed to purely consumptive spending raises growth prospects and productivity. Currently, the budget priorities in the crisis countries are geared toward consumption, for example, in the form of pensions, while investment-oriented spending lags behind the European average (see figure 4).

The euro crisis is now in its third year. The combination of a public debt, a banking crisis, and an economic crisis impedes quick solutions and brings politicians and economists into unchartered territory. The institutional set-up of the European Union will favor small steps or “can-kicking” solutions. This is not necessarily a bad thing—if the can is kicked in the right direction.


Alexander Börsch

Alexander Börsch is head of research at Deloitte & Touche GmbH, Germany.

Eurozone: Back to black