A lost decade for the Eurozone?
Frankfurt, 27 september 2012
While the European Central Bank’s Outright Monetary Transactions has significantly reduced the risk of a Eurozone breakup in the near term, the broader policy response to the crisis has still fallen short of the game-changer needed to restore long-term stability, according to the autumn Ernst & Young Eurozone Forecast (EEF).
Things will continue to get worse before they get better as the Eurozone faces rising unemployment, tightening corporate investment and further fiscal austerity. EEF predicts that Eurozone GDP will contract by 0.5% this year and only marginal growth of 0.1% in 2013, a downgrade from last quarter’s forecast. As the region’s economy rebalances and the process of fiscal tightening starts to ease, EEF projects GDP growth to pick up. But growth will be constrained for many years in the region by lingering concerns over stability and debt deleveraging by the public and the private sector.
Even this modest recovery though is predicated on the European authorities at a state and supranational level continuing to be innovative and supportive. Last month’s announcement was the beginning not the end of the process.
Marie Diron, senior economic adviser to the Ernst & Young Eurozone Forecast comments, “The recent so-called bazooka provided by ECB, in the form of a bond purchase program, will only serve as a temporary ‘sticking plaster’ for the Eurozone, albeit an essential one. We believe a more radical approach will be necessary over the coming months to ensure even the weakest of recoveries next year and in the future.”
Unemployment in the Eurozone will continue to rise peaking at 19.2 million or just over 12% in Q1 2014 meaning that consumers, particularly in the periphery, are unlikely to spend their way out of the recession. In Portugal, the jobless rate is expected to exceed 16%, while in Spain and Greece it will reach 26% and 27% of the workforce respectively.
Corporate investment will also be scaled back in response to tighter financing conditions, uncertainty over the stability of the single currency area and sluggish earnings. The contraction in investment spending is such that, by the end of 2016, the level of investment is expected to still be below its pre-crisis peak.
Mark Otty, Ernst & Young Area Managing Partner for Europe, Middle East, India and Africa comments; “As economic uncertainty continues to prevail across the Eurozone it is essential for business that policymakers continue the momentum and act decisively. The economy cannot afford corporates tightening their belts just when consumers are turning off the spending tap.”
A more federal Europe
Tensions in sovereign debt markets indicate that public finances are not the only concern in the peripheral economies, but divergences in competitiveness are also being taken into account. While the necessary economic adjustments in the periphery are yielding positive results, balance can only be achieved if countries, such as Germany, pursue policies to increase domestic spending and imports.
Marie comments, “External adjustments through wage restraint and productivity enhancement are crucial, as without improvements in competitiveness, fiscal austerity will keep these countries mired in deep recessions.”
Mechanisms of finance also need to be put in place to allow countries to manage the adjustment process while at the same time returning to growth without defaulting on their sovereign debt. This would entail a move toward a more federal Europe, where the provision of temporary and conditional support is provided in a more orderly to crisis-hit member states to ensure stability of their banking systems and sovereign finances.
Marie explains, “A closer banking and fiscal union is necessary for the Eurozone’s long-term survival. Indeed, it was always envisioned by the architects of the euro that currency union would lead to deeper economic and fiscal integration.”
Policy reform required
The list of measures required to keep the Eurozone in its current form is long and politically challenging. It includes enlargement of the European Stability Mechanism (ESM), a banking union, progress towards fiscal union and a shift in macro policy so that it is focused less on austerity and more on growth.
Marie comments, “Although the agreement to shift banking supervision to the Eurozone level is an encouraging step forward, a properly integrated banking system requires pooling not just of regulatory oversight but also support. A number of Eurozone countries have banking sectors that are just too large for their national governments to support. Without shared fiscal responsibility in the form of deposit guarantees these national banking systems will remain at risk.”
Proactive stance from the ECB
Serious downside risks remain to the forecast and a key assumption underlying EEF’s GDP prediction is that the ECB embarks upon additional non-conventional policy measures to address difficulties in funding markets and provide governments more time to introduce structural reforms needed to put the single currency area on a firmer footing.
The ECB is already close to the limits of what it can do with conventional monetary policy as it has reduced its key interest rate from 1% to 0.75%, a record low for the Eurozone. EEF believes that this will now be the bottom of the current easing cycle. However, a further rate cut cannot be ruled out if the economy deteriorates more sharply than expected.
Although the recent ECB bond purchase program announcement resulted in much needed market confidence Marie comments, “We continue to believe that a better path for the ECB would be to engage in full quantitative easing (QE), allowing it to buy any assets it chooses. Such a strategy could be used by the ECB to help banks that are running out of eligible collateral to access its liquidity operations.”
The events of the past five years are likely to have caused permanent damage to the potential output growth of many of the Eurozone economies, with the largest losses coming in countries at the epicenter of the sovereign debt crisis. This together with austerity measures, credit constraints, weakening foreign demand and a failure to address long-term competitiveness issues will weigh on growth for the next decade.
Otty concludes, “The outlook for the Eurozone economy remains subdued and it faces many hurdles. However competitiveness and growth must remain top of the agenda for Eurozone leaders if it is to compete long term on the world stage.”
About the Ernst & Young Eurozone Forecast
The forecasts and analyses presented in the EY Eurozone Forecast are based on the European Central Bank’s model of the Eurozone economy. This model embeds state-of-the-art economic theory and techniques and is used by the ECB to produce its quarterly forecasts of the euro area.
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