The Global Economy No. 4 - May 16, 2012


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

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The Global Economy No. 4 - May 16, 2012

  1. 1. The Global EconomyMonthly letter from Swedbank’s Economic Research Departmentby 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 globalforecast and Swedbank Economic Outlook, concern Since the crisis in the euro zone has picked up andfor Greece, and an exit from the euro, has picked growth data for China has become weaker thanup. This has consequences for financial market expected, the probability for the worse scenario hasstability, with bank runs and capital flight possibly increased. However, since the outcome of the newalso occurring in other crisis-struck countries. In election is unclear, and also whether Greece couldaddition, the real economy could become much stay in the euro zone or not depending on theweaker. relations to other euro zone countries, we find it too soon to revise our main scenario forecast.In our main scenario, we assumed that Greecewould stay in the euro zone and that Spain could Since April, the GDP growth has surprised on theavoid needing emergency loans from the euro zone upside for Germany and also the euro zone, withand the IMF. A scenario with a worsened outcome 0.5 % and unchanged GDP-level in quarterly termsfor 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 inoil price, would lead to a new global recession with line with our expectations (0.55 % compared to 0.5growth coming down to 2 % or below in the next %). Chinas growth, however, has been weaker thancouple 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: Internet: Responsible publisher: Cecilia Hermansson, +46-8- 5859 7720, Magnus Alvesson, +46-8-5859 3341, Jörgen Kennemar, +46-8-5859 7730, ISSN 1103-4897
  2. 2. The Global Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 4 • 16 May 2012concern for a hard landing in China has become against the backdrop of such a harsh reality. Therestronger, but on the other hand, China’s economic have already been suggestions to extend thepolicy 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 CommissionThe oil price has fallen more than we expected inApril. Still, the average price of our forecast of 119 0 ‐1dollars per barrel is close to the annual price so far. ‐2We find it likely that a downward revision will have ‐3to be made, and thereby the outlook for the world ‐4economy improves somewhat. ‐5 ‐6 2012In conclusion, the financial market turbulence hasincreased since our forecast was published in April, ‐7 2013 ‐8and the risks for a weaker scenario in Europe and ‐9China have grown. On the other hand, growthoutcome in Europe in the first quarter surprised uson the upside, and the oil price may have lessnegative consequences for the world economy thanexpected. 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 fiscalthe last few weeks due to the political outcome in pact, and in his discussions with Germany he mightGreece. accept the addition of a growth pact. At the same time he has agreed to slash the French budgetAfter the elections in euroland, growing deficit to 3% of GDP next year, but wants to extenduncertainty about the union’s future the goal of a balanced budget until 2017. If FranceThe pattern is clear. Local elections in Italy, state meets the 3% target next year, it would representelections in Germany, parliamentary elections in between 20 and 25 billion euro in additional taxesFrance and Greece: parties that supported austerity and reduced spending. Taxing the rich andand budget discipline have lost public support, while companies more than already promised won’t bethose that appealed to recession-weary voters by enough. Austerity is needed, which the presidentspreading hopes of growth and stimulus have won. wasnt open to during the election campaign.Economics Professor Barry Eichengreen talks If the IMF’s growth forecasts for France prove moreabout a trust deficit in the euro zone on several accurate than the EU Commission’s (0.5% GDPlevels. The elections show that this deficit has growth next year instead of 1.3%; our forecast ingrown between the populace and established April was 0.6%), even more austerity would bepoliticians. needed.The outcome of the elections will have The Greek parties that don’t support the austerityconsequences not only for the countries involved program with the IMF and EU have avoidedbut also the euro zone and the currency union as a mentioning that the country may have to exit thewhole. While interest in adding a growth pact to the euro depending on how it addresses austerity. Afiscal pact had already increased among euro new election would probably increase support forpoliticians, including Germans, and officials in the the parties that oppose the program. Its possibleEU Commission, the results speak volumes. Unless they are coldly calculating that the euro countriesthe balance between growth and austerity is will again accept that Greece won’t comply with theimproved, there is a risk that the national elections program, since the cost of kicking it out of the euroin Germany and Italy next year will be a boon for zone, or if Greece decides to leave, is too high. Atprotest parties as well as anti-immigrant parties. least 70% of Greeks support the euro, the sameThis could compromise the stability of the euro percentage (though not necessarily the samezone economically, financially and politically. people) that now supports the protest parties. DoThe EU Commission’s current forecast shows that a they realize what a dangerous game their politiciansnumber 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 thegrowth is weaker than the Commission is euro. The net benefit of its small export sector’santicipating, the deficit could be even bigger. A potential gains would quickly disappear as therenegotiated fiscal pact would then be expected 2 (5)
  3. 3. The Global Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 4 • 16 May 2012domestic economy worsens. Greeks’ debts would Just as it was difficult to understand thedecrease, but so would their assets. Inflation would consequences of letting Lehman Brothers goincrease. 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 adefaults would make it difficult for Greece to access Greek default and in the long run its leaving theforeign capital for years. Even if the country can euro zone. The ECB has already stated thatsoon reach a primary surplus (i.e., a budget surplus emergency loans will not be available if the countryexcluding interest payments), there is no assurance has solvency problems, which would be the case. Itit would last and that austerity wouldnt be needed is questionable whether the euro countries will beanyway. 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 Greecerenegotiated program unless Greece first shows it and the rest of the euro zone has to be betteris prepared to follow it. Although a country managed, whereas economic concerns havetechnically cant leave the euro zone, pragmatism probably already shifted from Greece to the biggercould gain the upper hand, i.e., a way is found to countries of Spain and Italy.make it possible. The other euro countries arerunning out of patience, and their strident reaction Speculation that Spain will need a support packagemay be a signal to the Greek protest parties not to from the EU, and possibly from the IMF, has growncount on additional support. after its banking system was pushed to the brink of collapse. A few questions still remain. Is a buffer ofRepresentatives of the euro countries – politicians around 120 billion euro enough if 310 billion hasand central bank governors – believe that the euro already been lent to the real estate sector? Evenzone could survive if Greece exited the euro. The now bad loans are estimated at 180 billion. If realfirewalls through stability facilities and additional estate prices continue to drop, there is a risk thatsupport from the IMF, as well as measures to the price tag could rise. Will all the banks managestrengthen European banks’ balance sheets, make to increase their buffers? If not, they will be able toit somewhat easier to accept a Greek exit. Of borrow 15 billion from the state, but how long wouldcourse, 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-calledand banks. For example, capital flight could cocos, contingent convertible bonds, enough toincrease from Portugal, Ireland, Spain and Italy if provide transparency and financial stability? Theinvestors expect these countries to also leave the financial market isn’t convinced, although Spain haseuro, as economics professor and Nobel Laureate taken steps in the right direction. At the same timePaul Krugman has suggested. Although this seems the Spanish government is becoming stricter withunlikely, it is enough that a few people have its spendthrift autonomous regions. The reformsuggested it to raise uncertainty. process continues, and so it does in Portugal and Ireland – three countries with crisis awareness thatEuro zone: Annual change in GDP, consumer prices and is totally different from what has been seen ingovernment 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 focusPercent Percent shifted to growth. In other words, we are now in a -1 75,0 second phase. Without growth, budget -2 72,5 consolidation wont 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 3 (5)
  4. 4. The Global Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 4 • 16 May 2012transfer and those that receive (moral hazard). The seen as a symbolic gesture: that Germany has nowcrisis countries have to show they belong in the softened its stance on the divergence betweencurrency union. northern and southern Europe. The impact of this shouldnt be exaggerated, however. With its lowCurrent 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 consumptionOpinions on how to create growth diverge among taxes are raised, which also reduces the risk ofpoliticians. 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 theimprovements in the public sector and attempts to service sector to competition and trade withinattract foreign investment in order to increase Europe. The inner market has to be furthereconomic productivity and strengthen the labor, French President Francois Hollande is Industrial production in certain euro countriesthinking about investments in roads and rails, more 115quantitative easing from the ECB and more hiring inthe public sector. He has even suggested to the 110French people a return to the previous retirement 105age of 60. 100 Index 2007:1 = 100The problem is that structural reforms, which are 95absolutely necessary for the crisis countries, could Germ anyhurt growth in the short term, while the positive 90 France Finlandeffects would have to wait until the medium or long Eurozone 85term. Italy Spain 80 GreeceWhat can be done that will also have an impact in Sweden 75the near term? There is little room for a debt-financed stimulus, except in countries with balanced 70budgets or surpluses. Even today 13 of the 17 euro 06 07 08 09 10 11countries are expected to miss the financial pact’s Source: Reuters EcoW intarget next year. That leaves Germany, Finland, The fact that northern Europe is doing well is alsoEstonia and Luxembourg. At the same time valuable. In Germany, industrial production is backGermany has a national debt of around 80% of to the same levels as before the crisis. ManpowerGDP and is maintaining a policy that will eventually would then be able to move to regions withreduce the debt ratio. demand. Since financing costs are low in Germany, Sweden and a few other countries, investments thatThere has been a shift in Germany, whose leaders are needed one way or another could be pushednow say they could accept inflation slightly above forward.the euro zone average. Finance Minister Schäubleis talking about higher wage increases, but if The euro zone wont be able to avoid a recession,inflation is also higher real wage growth wont differ and the crisis countries will see their economiesthat much. Their statements probably should be continue to shrink. Unemployment has risen, and it 4 (5)
  5. 5. The Global Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 4 • 16 May 2012can be expected to continue to increaseconsidering the negative growth, budget austerityand credit austerity.We have to expect a lengthy period of fiscalausterity and weak growth prospects. Monetarypolicy will be expansive, but wont be enough tooffset the effects of budget consolidation and debtrelief. The ingenuity of politicians is now being putto the test as they try to find a creative mix betweentax increases (and in some cases cuts) andspending cuts (and in some cases increases). It isimportant to maximize growth under the conditionthat budget consolidation and deleveraging iscontinued.At the same time structural reforms have to be atthe top of the priority list, since the crisis is nowproviding an opportunity to improve how themarkets work. Many insiders want to try to preventchanges, but for those groups who stand outsidethe labor market, for example, it is critical that themarket becomes more flexible and gives youngpeople the chance to get established.Postponing the balanced budget requirement foranother year, and stimulating where possible, mayseem reasonable, but only if the necessarystructural reforms are implemented as well. Cecilia HermanssonSwedbankEconomic 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 preparationSE-105 34 Stockholm, Sweden of the analyses reported in this publication. However, we cannot guarantee the accuracy orPhone +46-8-5859 7740 completeness of the report and cannot be held responsible for any error or omission in underlying material or its use. Readers are encouraged to base any (investment) on other material as well. Neither Swedbank nor its employees may be held responsible forLegally responsible publisher losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’sCecilia Hermansson, +46-88-5859 7720. monthly The Global Economy newsletter.Magnus Alvesson, +46-8-5859 3341Jörgen Kennemar, +46-8-5859 7730 5 (5)