The summer has seen a swathe of positive data that appear to point finally to a growth recovery in the hard-hit eurozone. But the question ministers and central bankers must answer as they gather for this year’s annual meeting of the International Monetary Fund is whether this is a cyclical blip or a genuine sign of a resolution to the crisis that has cast gloom over the world economy for years.
On the face of it, the numbers are impressive. The eurozone’s economy exited its six-quarter recession with slightly more energy than had been expected, as GDP rose 0.3% quarter-on-quarter in the three months to June. The recovery in manufacturing accelerated in August, business confidence is rising, and households are starting to spend again.
Germany led the zone out of recession as its GDP growth jumped 0.7% quarter-on-quarter after a flat performance in the first quarter, helped by a strong rebound in construction activity. Meanwhile, France also emerged out of recession with much stronger than expected growth of 0.5% – the strongest rise since the first quarter of 2011.
There were also modest rises in Austria (0.2%), Belgium (0.1%) and Slovakia (0.3%). Meanwhile, Portugal – one of the bailout countries that have been the public examples of the problems in the eurozone – exited recession following 10 quarters of contraction, as GDP jumped 1.1%.
While large parts of the 17-nation area continued to contract, there were signs that the conditions were getting worse more slowly. The rate of contraction eased markedly in Italy, Cyprus, Spain and Greece. “The eurozone is like a glass that is more than half full but the empty space is still fairly substantial,” says Hung Tran, executive managing director of the Institute of International Finance.
Investors are starting to take an interest. The latest Merrill Lynch Fund Manager survey showed optimism towards the eurozone at a nine-year high. Many fund managers are now overweight on the region. Meanwhile, German voters’ strong endorsement of Angela Merkel points to no sudden change in eurozone policy.
Some economists too are ready to embrace the positive signs. “Good news is not bad news in disguise,” says Richard Barwell, senior European economist at Royal Bank of Scotland. While he admits it would be “absurd” to seize on one quarter’s data, he says the crucial impact could be the challenge to what he calls the “eurosceptic narrative”.
He does have a point. Two years ago sceptics had doubted the survival of the zone’s banking system until the ECB put the long-term refinancing operation (LTRO) in place. A year ago the disintegration of the euro was on the cards until ECB president Mario Draghi unveiled the Outright Monetary Transaction policy and its pledge to buy member states’ bonds.
“Ever since the ECB stopped the rot in August 2012 with its promise to keep all reform countries in the euro, economic confidence has rebounded across the eurozone,” says Holger Schmieding, chief economist at Germany’s Berenberg Bank. “Everything in the eurozone has gone the right way.”
FALSE DAWNS
But not everyone is convinced the economic recovery is a sign the zone has turned the corner. Many point to repeated false dawns, particularly in 2011 and 2012.
The first concern is that the recovery might just be a flash in the pan. Ted Scott, director of global strategy at F&C Investments, says a genuine recovery should see growth rates hitting what he calls “escape velocity”.
“There could be a decent rebound in the second half of this year in Germany, but for the periphery countries it is a case of things not being quite as bad,” he says.
The wider issue is whether economic recovery is enough to solve the debt crisis in Europe. According to Jonathan Loynes, chief European economist at Capital Economics, it does not eradicate the risk some of the peripheral economies will undergo some form of sovereign default.
“Without a further improvement in their budget positions, countries would need very rapid growth to bring their debts down to sustainable levels in a reasonable time frame,” he says. “With austerity close to its limits, some countries may yet choose or be forced to follow Greece in turning to a third escape route from their debts – namely, default.”
Nicholas Crafts, director of the Centre for Competitive Advantage in the Global Economy at Warwick University, says that on face value the lessons of history do point towards a default.
Drawing on his longstanding research into the Great Depression, he says the event that provides the most direct parallel between the two crises is the collapse of the gold standard in the mid-1930s – the end of the system by which virtually all major economies converted their currencies into gold at a fixed parity.
Countries that left the gold standard suffered major currency devaluations but regained autonomy over monetary policy with lower interest rates and lower real wage rates. So surely a strategy of devalue and default is the right route to recovery for euro countries, if it was for economies in the 1930s?
“Leaving the gold standard was the key to recovery in the 1930s. Taken at face value, it does seem that for southern Europe to follow the path their predecessors trod 80 years ago would look quite attractive. Devalue and default would seem to be quite a sensible thing to do – and much less painful than trying many years of fiscal consolidation and trying to force an internal devaluation,” says Crafts.
Of course there is a “but”. “Although the natural thing would be to devalue and default, whether exit can be achieved without triggering a massive financial crisis is doubtful,” he says. “It could well engender capital flight and a devastating bank run.”
He says Germany is probably worried about the impact defaults by peripheral countries would have on its banking system in a world where banks form a much higher share of economies than they did 80 years ago.
Scott at F&C says if politicians are really determined to make the eurozone work successfully, they must embrace full political and fiscal union. “There is huge political will to keep the 17 countries intact, which analysts have consistently underestimated, but in order to do so it has led to a ‘sticking plaster’ approach which buys time rather than implementing the necessary fundamental reforms,” he says.
FULLY FEDERAL EUROPE
The holy grail of reform is achieving a “fully-federal Europe” with a banking union, a fiscal union and a constitution that would finally end Europe’s democratic deficit. Crafts agrees this would be the ideal solution, as many critics have complained that European institutions lack democratic legitimacy although they have the power to take decisions that affect the lives of millions of Europeans.
Brussels has put in place a “fiscal pact” and the beginnings of a banking union in terms of a single supervisory mechanism (SSM), by which the ECB will become the supervisor for 150–200 of the eurozone’s 6,000 biggest banks, followed by a single resolution mechanism (SRM).
Crafts says policymakers have chosen to muddle through the crisis by employing bailouts for countries such as Greece, Portugal and Ireland and imposing tough austerity programmes. Scott says the lack of political will to embark on bold reforms means “the muddle-through scenario is likely to continue for the foreseeable future.”
To get an idea of what muddling through could be like, one need only take a look at a report by GSEE, Greece’s main private-sector union, which says that it will take at least 20 years for unemployment in Greece to drop from its current 27% pre-crisis levels of below 10%. The study also suggests that by 2014 Greeks’ purchasing power will be half of what it was before the crisis began.
Despite that, Scott expects the status quo to remain, with the troika of the European Commission, the International Monetary Fund, and especially the ECB, providing the necessary crisis support to prevent contagion and keep bond yields low. “It is not a solution, however, and the divergent nature of the currency union will mean that growth remains elusive without the necessary fundamental reforms,” he says.
“This requires significant strides towards a fiscal and political union as well as a common currency and major structural reforms in the periphery countries to remove the obstacles to growth. Such a transformation, if it does happen, is likely to take many years, and without it the outlook for growth remains subdued.”
ECB IN FOCUS
Investors are looking to the ECB to take more drastic action. Last month President Mario Draghi kept rates on hold but left the door open to a cut. Elga Bartsch, Morgan Stanley’s chief European economist, says the bank must not just cut rates to 0.25% from the current 0.50%, but go further.
She urges the bank to unveil a new LTRO but “elegantly link it” to its forward guidance on interest rates, by offering it at a fixed rate of 0.25% rather than tracking the ECB rate. “This is central bankers putting their money where their mouth is,” she says.
According to Graham Turner, head of GFC Economics, the big test for the resilience of the eurozone’s recovery will be how it copes with rising bond yields when the US Federal Reserve starts to withdraw its enormous monetary stimulus package.
“The success of peripheral countries in reducing their budget deficits is crucial to ensure bond yields remain resilient to future policy action in the US,” he says, pointing to the €2.6 billion primary state surplus in Greece for the first seven months of the year, a turnaround from the €3.1 billion deficit for the same period in 2012.
He says one of the biggest downside risks remains the high number of unemployed in peripheral countries, and the implied social and political instability. The jobless rate declined marginally in Portugal, Spain and Italy in June, but rose in Greece in April.
For Crafts and his long view of history, this is one of the most alarming aspects. “Long periods of austerity create a lot of push back,” he says. “Very recent research says that there is a clear correlation between prolonged stagnation and the rise of right-wing extremism.
“If that’s where Greece, Spain, Italy and Portugal are in a couple of years’ time, then I can imagine there would be a political response, and we will start to see a loss of faith in the market economy.”
For Bartsch, the outlook for the eurozone through to mid-2014 is “peppered with potential pitfalls”. This list includes a potential third Greek bailout, delays to Portugal achieving full market access, Irish anger over austerity, Italian politics and the various steps that need to be taken to complete banking union.
“All these events are potentially designed to create some uncertainty in markets, and the sooner they are dealt with and out of the way, the better. In the meantime it pays to stay cautious as far as European growth numbers are concerned.”