Euro-zone recession threatens global economy

Social order withers while politicians dither

By Kiron Sarkar

The euro-zone economy is deteriorating alarmingly. While the German-inspired policy of austerity is essentially right, its implementation, over far too short a period of time, is forcing the region into recession. Social disorder, especially as the weather improves next spring, is a real probability.

The severe austerity measures have impacted Greece, Spain, and Portugal in particular (Ireland has stabilized and there are positive signs in Italy), though core euro-zone countries, such as France and even Germany, are now affected. Both France and Germany are likely to report a decline in GDP this quarter.

The negative impact of fiscal multipliers suggests that further cuts in spending and/or tax increases will reduce GDP by more than the aggregate of tax increases and spending cuts, thereby increasing budget deficits and debt-to-GDP for Greece, Portugal and Spain. (A view expressed by the IMF, though not accepted by the European Union.)

The EU revised its forecast for 2013 euro-zone GDP to just 0.1% with a decidedly negative outlook, down from 1% just last week and far more anemic than the 0.25% pace predicted by private-sector economists. The EU also increased French and Spanish projected budget deficits and reduced GDP forecasts materially. To date, Spain, and increasingly France, have reported wildly optimistic forecasts. A centralized budgetary system (coming, in spite of opposition from the relevant countries) will stop this practice, most likely next year.

Germany’s leadership vacuum

German Chancellor Angela Merkel is having to balance domestic considerations (increasing anti-bailout sentiment), with her strong desire to achieve political union in the euro zone — certainly not a French policy.

But to achieve political union, Germany realizes that banking and fiscal union must come first. That said, the Germans are unwilling to move forward on banking union, especially if it involves facing potential financial exposure.

Germany’s fiscal outlook, while stable, is not shatterproof — it does not have a blank checkbook. To date, Merkel and the euro zone have relied on ECB President Mario Draghi to calm markets, which his recent OMT (bond buying) proposal has achieved.

However, without some policy follow-through, the current calm cannot last. Comments by Merkel last week suggest she understands that action is necessary, though she remains an inherently cautious politician, unwilling to adopt potentially difficult political and policy decisions. She remains focused on the German general elections in September 2013 and wants to delay any contentious measures until after these elections — a position which is unlikely to hold.

Some members of Merkel’s coalition will oppose further measures to support the euro zone, a problem as any further aid for Greece, such as releasing the next tranche of a previously agreed bailout funds, will require the approval of the German Parliament.

The opposition SPD party, which Merkel had to rely on recently to pass legislation to set up the European Stability Mechanism firewall, is far more euro-zone supportive but wants “political concessions” if it is to assist Merkel again — something she so far has refused to concede.

The time has come for Merkel to show political leadership, as opposed to trying to fix (temporarily) problems as and when they become critical. The chancellor is a highly intelligent, able and practical politician, free from dogma, but leadership, accompanied by effective policy initiatives, is now critical.

France in decline

Economic conditions in Spain and, increasingly France, are worsening. I believe the ratings agencies will downgrade Spain to junk-status in the next few months. Spanish Prime Minister Mariano Rajoy, benefiting from the ECB-proposed bond-buying program (the OMT), continues to dither and deny the obvious, which is that Spain needs a bailout.

Spain’s budget deficit will exceed the target of 6.3% materially this year and the economy continues to contract — unemployment exceeds 25%. Yields on Spanish debt had declined materially following the announcement of the ECB’s OMT program, but Rajoy’s dithering has pushed 10-year yields back up to around 6% — an unsustainable level.

And France looks as if it is going the way of Spain and Portugal, with increasing unemployment, uncompetitive industry, a worsening troika of trade, current account and budget deficits, plus ineffective leadership. Taken together, France faces losing its AAA credit rating in the coming months.

The worsening French economy is likely to pose the greatest threat to the euro zone. Relations between Merkel and French President Francois Hollande continue to deteriorate. However France can do little, given its problems, and is being ignored increasingly by Germany.

Meanwhile, the Greek saga continues and the country will default — it is only a matter of time, as will Spain and Portugal, most likely. The ECB has been the savior of the euro zone to date, but Draghi stated that the ECB was “done” with Greece, in other words it’s up to the politicians. The ECB, however, is likely to cut interest rates further and, indeed, may introduce unsterilized quantitative easing once euro-zone inflation declines below 2%, which is expected next year.

The bottom line is that policy makers have to act — something euro-zone leaders have proved incapable of doing so far.

I continue to believe that the euro zone is the greatest threat to the global economy and, unfortunately, no resolution is in sight. The euro   should continue to weaken.