The Global Economy No. 4 - May 16, 2012:Europe: A more balanced mix of austerity and growth

1. The Global Economy
Monthly letter from Swedbank’s Economic Research Department
by Cecilia Hermansson No. 4 • 16 May 2012
Europe: A more balanced mix of austerity and growth
 A new election in Greece raises the risk that Greece will default on its payments
and may have to exit the euro. Since a majority of Greeks wants to keep the euro,
there is still the possibility that the new election will be a euro election. Otherwise
we can expect an even bigger victory for the parties that won’t commit to austerity.
They are playing a dangerous game, however, since the patience of the other euro
countries is wearing thin.
 The results of local elections in Germany and Italy, as well as the national
elections in Greece and France, indicate a growing trust deficit between the
people and established parties. France’s new president, Francois Hollande, will
have to accept austerity if he is going to keep his promise to reduce the budget
deficit to 3% of GDP next year. This could surprise his voters. Hollande, the EU
Commission, the ECB and even Angela Merkel are now talking about a better
balance between austerity and growth.
 Allowing another year to balance public finances and increase investments where
possible may seem reasonable from an economic and political perspective, but
only if structural reforms are implemented to strengthen economic growth and
competitiveness in the longer term. Politicians will also have to be more creative in
designing fiscal policies to protect groups who are at risk and to maximize growth,
under the condition that budget consolidation and deleveraging continue.
If we had published the forecast today … scenario and a better scenario had a probability of
th, 60 % and 10 %, respectively.
Since April 24 when we published our global
forecast and Swedbank Economic Outlook, concern Since the crisis in the euro zone has picked up and
for Greece, and an exit from the euro, has picked growth data for China has become weaker than
up. This has consequences for financial market expected, the probability for the worse scenario has
stability, with bank runs and capital flight possibly increased. However, since the outcome of the new
also occurring in other crisis-struck countries. In election is unclear, and also whether Greece could
addition, the real economy could become much stay in the euro zone or not depending on the
weaker. relations to other euro zone countries, we find it too
soon to revise our main scenario forecast.
In our main scenario, we assumed that Greece
would stay in the euro zone and that Spain could Since April, the GDP growth has surprised on the
avoid needing emergency loans from the euro zone upside for Germany and also the euro zone, with
and the IMF. A scenario with a worsened outcome 0.5 % and unchanged GDP-level in quarterly terms
for the euro zone, a hard landing in China, a more respectively, compared with our forecast of -0.1 %
restrictive fiscal policy in the US and an even higher and -0.2 % in April. The US economy has grown in
oil price, would lead to a new global recession with line with our expectations (0.55 % compared to 0.5
growth coming down to 2 % or below in the next %). Chinas growth, however, has been weaker than
couple of years. The probability was assumed to be expected. Industrial production did not reach 10 %
30 % for this worse scenario, while the main in annual growth, a lower figure than 9.3 % has not
been seen since May 2009. The financial markets
Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46-8-5859 7740
E-mail: ek.sekr@swedbank.se Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson, +46-8-
5859 7720, Magnus Alvesson, +46-8-5859 3341, Jörgen Kennemar, +46-8-5859 7730, ISSN 1103-4897

2. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 4 • 16 May 2012
concern for a hard landing in China has become against the backdrop of such a harsh reality. There
stronger, but on the other hand, China’s economic have already been suggestions to extend the
policy is being made more expansionary, timeframe when the requirements have to be met.
decreasing the risks somewhat.
Budget balance, % of GDP, forecast of the EU Commission
The oil price has fallen more than we expected in
April. Still, the average price of our forecast of 119 0
‐1
dollars per barrel is close to the annual price so far.
‐2
We find it likely that a downward revision will have ‐3
to be made, and thereby the outlook for the world ‐4
economy improves somewhat. ‐5
‐6
2012
In conclusion, the financial market turbulence has
increased since our forecast was published in April, ‐7 2013
‐8
and the risks for a weaker scenario in Europe and
‐9
China have grown. On the other hand, growth
outcome in Europe in the first quarter surprised us
on the upside, and the oil price may have less
negative consequences for the world economy than
expected. We maintain our global forecast of 3.1 %
for 2012 and 3.4 % for 2013, but we realize that the In his campaign, the new French president,
risks for weaker developments have increased in Francois Hollande, pledged to renegotiate the fiscal
the last few weeks due to the political outcome in pact, and in his discussions with Germany he might
Greece. accept the addition of a growth pact. At the same
time he has agreed to slash the French budget
After the elections in euroland, growing deficit to 3% of GDP next year, but wants to extend
uncertainty about the union’s future the goal of a balanced budget until 2017. If France
The pattern is clear. Local elections in Italy, state meets the 3% target next year, it would represent
elections in Germany, parliamentary elections in between 20 and 25 billion euro in additional taxes
France and Greece: parties that supported austerity and reduced spending. Taxing the rich and
and budget discipline have lost public support, while companies more than already promised won’t be
those that appealed to recession-weary voters by enough. Austerity is needed, which the president
spreading hopes of growth and stimulus have won. wasn't open to during the election campaign.
Economics Professor Barry Eichengreen talks
If the IMF’s growth forecasts for France prove more
about a trust deficit in the euro zone on several
accurate than the EU Commission’s (0.5% GDP
levels. The elections show that this deficit has
growth next year instead of 1.3%; our forecast in
grown between the populace and established
April was 0.6%), even more austerity would be
politicians.
needed.
The outcome of the elections will have
The Greek parties that don’t support the austerity
consequences not only for the countries involved
program with the IMF and EU have avoided
but also the euro zone and the currency union as a
mentioning that the country may have to exit the
whole. While interest in adding a growth pact to the
euro depending on how it addresses austerity. A
fiscal pact had already increased among euro
new election would probably increase support for
politicians, including Germans, and officials in the
the parties that oppose the program. It's possible
EU Commission, the results speak volumes. Unless
they are coldly calculating that the euro countries
the balance between growth and austerity is
will again accept that Greece won’t comply with the
improved, there is a risk that the national elections
program, since the cost of kicking it out of the euro
in Germany and Italy next year will be a boon for
zone, or if Greece decides to leave, is too high. At
protest parties as well as anti-immigrant parties.
least 70% of Greeks support the euro, the same
This could compromise the stability of the euro
percentage (though not necessarily the same
zone economically, financially and politically.
people) that now supports the protest parties. Do
The EU Commission’s current forecast shows that a they realize what a dangerous game their politicians
number of countries (13 of 17) will not meet the are playing?
fiscal pact’s goal of a budget deficit of 3% of GDP. If
For Greece, there is little to gain by abandoning the
growth is weaker than the Commission is
euro. The net benefit of its small export sector’s
anticipating, the deficit could be even bigger. A
potential gains would quickly disappear as the
renegotiated fiscal pact would then be expected
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3. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 4 • 16 May 2012
domestic economy worsens. Greeks’ debts would Just as it was difficult to understand the
decrease, but so would their assets. Inflation would consequences of letting Lehman Brothers go
increase. Capital flight would result, the banking bankrupt, it is difficult to see the psychological,
system would collapse and in the long run the economic, social and political consequences of a
defaults would make it difficult for Greece to access Greek default and in the long run its leaving the
foreign capital for years. Even if the country can euro zone. The ECB has already stated that
soon reach a primary surplus (i.e., a budget surplus emergency loans will not be available if the country
excluding interest payments), there is no assurance has solvency problems, which would be the case. It
it would last and that austerity wouldn't be needed is questionable whether the euro countries will be
anyway. able, or want, to continue to support Greece if they
don’t have to for the sake of stability in the region.
It is unlikely that the euro countries will accept a Ultimately, the political relationship between Greece
renegotiated program unless Greece first shows it and the rest of the euro zone has to be better
is prepared to follow it. Although a country managed, whereas economic concerns have
technically can't leave the euro zone, pragmatism probably already shifted from Greece to the bigger
could gain the upper hand, i.e., a way is found to countries of Spain and Italy.
make it possible. The other euro countries are
running out of patience, and their strident reaction Speculation that Spain will need a support package
may be a signal to the Greek protest parties not to from the EU, and possibly from the IMF, has grown
count on additional support. after its banking system was pushed to the brink of
collapse. A few questions still remain. Is a buffer of
Representatives of the euro countries – politicians around 120 billion euro enough if 310 billion has
and central bank governors – believe that the euro already been lent to the real estate sector? Even
zone could survive if Greece exited the euro. The now bad loans are estimated at 180 billion. If real
firewalls through stability facilities and additional estate prices continue to drop, there is a risk that
support from the IMF, as well as measures to the price tag could rise. Will all the banks manage
strengthen European banks’ balance sheets, make to increase their buffers? If not, they will be able to
it somewhat easier to accept a Greek exit. Of borrow 15 billion from the state, but how long would
course, there is still uncertainty how much the it last? Is the latest plan with independent auditors,
contagion would spread to other crisis countries transfers to a bad bank and the use of so-called
and banks. For example, capital flight could cocos, contingent convertible bonds, enough to
increase from Portugal, Ireland, Spain and Italy if provide transparency and financial stability? The
investors expect these countries to also leave the financial market isn’t convinced, although Spain has
euro, as economics professor and Nobel Laureate taken steps in the right direction. At the same time
Paul Krugman has suggested. Although this seems the Spanish government is becoming stricter with
unlikely, it is enough that a few people have its spendthrift autonomous regions. The reform
suggested it to raise uncertainty. process continues, and so it does in Portugal and
Ireland – three countries with crisis awareness that
Euro zone: Annual change in GDP, consumer prices and is totally different from what has been seen in
government debt as a share of GDP (%)
Greece.
4 87,5
Inflation
3 85,0 Austerity or growth – or both?
2 82,5
In the first phase the financial market’s focus was
on austerity, but after the fiscal pact was created
1 GDP Growth 80,0 and the ECB lent 1 trillion euro to banks to reduce
0 77,5
credit austerity and stabilize the situation, the focus
Percent
Percent
shifted to growth. In other words, we are now in a
-1 75,0 second phase. Without growth, budget
-2 72,5
consolidation won't work, and if the recession
Soveriegn debt, % of GDP worsens, democracy could be at risk.
-3 70,0
From a purely economic perspective, it would be
-4 67,5
better if the crisis countries had more time to create
-5 65,0 a balance, but there is a trust deficit vis-à-vis the
06 07 08 09 10 11 financial markets and the crisis countries have to
Source: Reuters EcoWin show that they can achieve budget discipline, as
well as a trust deficit between those countries that
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4. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 4 • 16 May 2012
transfer and those that receive (moral hazard). The seen as a symbolic gesture: that Germany has now
crisis countries have to show they belong in the softened its stance on the divergence between
currency union. northern and southern Europe. The impact of this
shouldn't be exaggerated, however. With its low
Current account balance, % of GDP, in several EU countries, unemployment and relatively good growth,
forecast of the EU Commission Germany could reduce its current account surplus
10
by importing more for domestic consumption.
5 The EU Commission is open to the possibility of
channeling funds through the European Investment
0 Bank (EIB), which could be used for investment.
Some form of euro bond solution to finance these
Percent
-5 projects is also being discussed. However, the
sums being discussed are small in relation to the
-10 P ortugal
needs. The ECB has suggested liquidity support for
G reece
G erm any
banks to encourage lending to small businesses.
-15
Ireland
S pain
Tax cuts for small businesses could lead to more
Italy
S weden
hiring, as could tax cuts for at-risk groups such as
young people. Unconventional fiscal policy is being
-20
92 94 96 98 00 02 04 06 08 10 12 discussed, e.g., lowering taxes on labour income to
So urce: R e uters EcoW in
spur growth at the same time that consumption
Opinions on how to create growth diverge among taxes are raised, which also reduces the risk of
politicians. While Germany’s chancellor is pushing deflation.
for structural reforms in labor and product markets,
divestment of state-owned companies, efficiency Structural reforms could also involve opening up the
improvements in the public sector and attempts to service sector to competition and trade within
attract foreign investment in order to increase Europe. The inner market has to be further
economic productivity and strengthen the labor strengthened.
supply, French President Francois Hollande is
Industrial production in certain euro countries
thinking about investments in roads and rails, more
115
quantitative easing from the ECB and more hiring in
the public sector. He has even suggested to the 110
French people a return to the previous retirement 105
age of 60.
100
Index 2007:1 = 100
The problem is that structural reforms, which are
95
absolutely necessary for the crisis countries, could Germ any
hurt growth in the short term, while the positive 90 France
Finland
effects would have to wait until the medium or long Eurozone
85
term. Italy
Spain
80
Greece
What can be done that will also have an impact in Sweden
75
the near term? There is little room for a debt-
financed stimulus, except in countries with balanced 70
budgets or surpluses. Even today 13 of the 17 euro 06 07 08 09 10 11
countries are expected to miss the financial pact’s Source: Reuters EcoW in
target next year. That leaves Germany, Finland, The fact that northern Europe is doing well is also
Estonia and Luxembourg. At the same time valuable. In Germany, industrial production is back
Germany has a national debt of around 80% of to the same levels as before the crisis. Manpower
GDP and is maintaining a policy that will eventually would then be able to move to regions with
reduce the debt ratio. demand. Since financing costs are low in Germany,
Sweden and a few other countries, investments that
There has been a shift in Germany, whose leaders are needed one way or another could be pushed
now say they could accept inflation slightly above forward.
the euro zone average. Finance Minister Schäuble
is talking about higher wage increases, but if The euro zone won't be able to avoid a recession,
inflation is also higher real wage growth won't differ and the crisis countries will see their economies
that much. Their statements probably should be continue to shrink. Unemployment has risen, and it
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5. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 4 • 16 May 2012
can be expected to continue to increase
considering the negative growth, budget austerity
and credit austerity.
We have to expect a lengthy period of fiscal
austerity and weak growth prospects. Monetary
policy will be expansive, but won't be enough to
offset the effects of budget consolidation and debt
relief. The ingenuity of politicians is now being put
to the test as they try to find a creative mix between
tax increases (and in some cases cuts) and
spending cuts (and in some cases increases). It is
important to maximize growth under the condition
that budget consolidation and deleveraging is
continued.
At the same time structural reforms have to be at
the top of the priority list, since the crisis is now
providing an opportunity to improve how the
markets work. Many insiders want to try to prevent
changes, but for those groups who stand outside
the labor market, for example, it is critical that the
market becomes more flexible and gives young
people the chance to get established.
Postponing the balanced budget requirement for
another year, and stimulating where possible, may
seem reasonable, but only if the necessary
structural reforms are implemented as well.
Cecilia Hermansson
Swedbank
Economic Research Department Swedbank’s monthly The Global Economy newsletter is published as a service to our
customers. We believe that we have used reliable sources and methods in the preparation
SE-105 34 Stockholm, Sweden
of the analyses reported in this publication. However, we cannot guarantee the accuracy or
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Legally responsible publisher losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s
Cecilia Hermansson, +46-88-5859 7720. monthly The Global Economy newsletter.
Magnus Alvesson, +46-8-5859 3341
Jörgen Kennemar, +46-8-5859 7730
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