In the present public discussion of economic adjustment in the euro area growth and austerity are often seen as competing objectives. In our view, however, this view is based on a rather mechanistic concept of economic growth.
At the root of the recession in the euro area is a lack of confidence in the ability of individual countries to achieve the necessary economic flexibility required for a monetary union of regions with divergent economic developments and in the capability of EU institutions to manage the present crisis. The restoration of confidence is essential to end the recession and return to economic growth. The question therefore is not whether to give priority to fiscal austerity or economic growth but to find the optimal degree of austerity and structural reforms for the maximisation of confidence.
In this regard, we consider the glass half full: Economic policies in Spain and Italy are going in the right direction and there has been considerable progress towards establishing a crisis management mechanism for EMU. However, much still needs to be done. Governments in Spain and Italy have to stay the course and the new government of France has to join the club of reformers. Moreover, the inconsistent two-level crisis management system, i.e. strict EU/IMF fiscal policy and unlimited ECB monetary policy, has to be turned into a consistent and effective regime. In our view, 2012 will be the decisive year for the future of the euro. At present, we still see a good chance for a successful stabilisation and consolidation of EMU.
It’s confidence, stupid!
In the present public discussion of economic adjustment in the euro area growth and austerity are often seen as competing objectives. In our view, however, this view is based on a rather mechanistic concept of economic growth. From national accounting identities it follows that higher consumption, investment and net exports raise GDP. If private demand is weak, the identity suggests that public and / or export demand ought to be raised to support GDP. Assuming that there is limited scope to influence exports in the short term the natural conclusion seems to be that it is up to public consumption and public investment to support growth. Hence, policies of public deficit reduction appear to undermine growth.
But this view, like most traditional economic models used to calculate “fiscal multipliers”, neglects the crucial role of confidence ‒ some would say “animal spirits” ‒ for economic growth. Confidence is needed for companies to invest, banks to lend, and consumers to spend. Without confidence of households, bankers, and entrepreneurs, any increase in public consumption and investment has in the best case temporary effects on growth; in the worst case the resulting deterioration of public finances can destroy confidence of private economic agents and have a lasting negative impact on growth. Hence, the most important task for economic policy is to restore confidence of domestic residents and foreign investors in economic and financial soundness, even if this implies temporary output losses caused by fiscal austerity and structural reform. Confidence will not only support investment by companies and avoid an increase of savings by households out of fear for the future, but it will also induce lending by domestic and foreign private financial institutions. As a result, there is less pressure for the immediate reduction of internal and external deficits and a lesser need for public adjustment funding by EU institutions and the IMF.
Policies to restore confidence have to focus on the attainment of fiscal sustainability, financial stability, and external competitiveness. In the following sections we briefly trace the well-known recent history of the loss of confidence in euro area sovereign debtors, review some of the action taken to restore confidence, and discuss possibly required additional measures. Our key conclusion is that risks to a successful stabilisation of the euro area remain high and that significant additional efforts both at the country and the EU level are required.
A brief history of the loss of confidence
We see two sources for the loss of investor confidence in euro area sovereigns: (i) doubts about the ability of countries to adjust their internal (public and private sector) and external (current account) deficits; and (ii) doubts about the effectiveness of the crisis management mechanism that has been built over the last two and a half years. The general deterioration of confidence in the viability of EMU can be seen from the development of German government bond yields, which are seen as a safe haven in the euro area sovereign debt market. As can be seen from chart 1, the yield of German federal debt securities fell in three rounds. The first round occurred after the collapse of Lehman Brothers in September 2008 triggered the global financial crisis, and the second when the financial crisis spread to the euro area sovereign debt market in late 2009. Yields recovered in the first half of 2011 when hopes increased that the authorities would find a solution for the euro crisis. They fell again in a third round as of mid-2011 when these hopes were disappointed. The historical lows of German government bond yields despite a fairly robust economy and signs of an increase in inflation over the medium term points to the deep distrust of investors in the long-term survival of the euro.
The loss of confidence in countries’ ability to adjust is visible from the development of spreads of Italian and Spanish government bond yields against German yields (chart 2). In Italy, spreads surged between mid-2011 and November 2011 when markets worried about the determination of the Berlusconi government to proceed with economic adjustment and fiscal consolidation. They eased thereafter not only thanks to the ECB’s generous injection of liquidity into the euro area banking sector but also on the back of hopes that the Monti government would take a more serious approach to reform and budget consolidation. In Spain, spreads moved higher throughout 2011 as doubts grew about the ability of the Zapatero government to implement economic reform and control the finances of the regional public authorities. Like in the case of Italy, spreads in Spain fell after the ECB began to flood euro area banks with liquidity and the Rajoy government took measures to ease labour market rigidities and crack down on fiscal deficits. However, the decline in spreads was less pronounced in Spain than in Italy and, more recently, Spanish spreads have exceeded those of Italy.
The difference in the recent development of government bond yield spreads of Italy and Spain illustrates nicely the role of confidence in influencing financial conditions and hence the outlook for growth. In our view, the Spanish govern-ment has launched a more ambitious fiscal adjustment programme and has undertaken more comprehensive reforms of the labour market than Italy. In Spain, the government intends to reduce the general government deficit from 8.5% of GDP in 2011 to 3.0% of GDP in 2013, and they have taken substantial measures on the spending and revenue side. The government has significantly cut severance compensation for dismissed workers and made it easier for companies facing hard times to pull out of collective bargaining agreements and to have greater flexibility to adjust employees’ working times, workplace tasks and wages depending on economic conditions. Moreover, unions and employers have agreed to wage increases substantially below the expected inflation rate. In Italy, the government has set out to reduce the general government deficit from an estimated 3.6% of GDP in 2011 to 0.5% in 2013, a more modest reduction although Italy’s debt ratio is far above that in Spain. Moreover, the Italian government has only marginally decreased administrative hurdles against lay-offs and reduced the attractiveness of the employment of temporary workers, so that incentives for employment have hardly improved. Still, markets have exhibited more confidence in Italy than in Spain.
In our view, the difference in market perception of Italy and Spain is to some extent related to differences in communication by the two governments. While the Monti government has been able to create some goodwill in the market by emphasising the strength and downplaying the weaknesses of its economic policy actions, the Rajoy government has struggled in two important areas. First, it has not been able to find a convincing response to the failure of the Zapatero government to miss its deficit target of 6% of GDP for 2011. This has reminded many market participants of the travails of the Papandreou government of Greece in 2009, which also disclosed a sharply higher deficit than initially envisaged. Second, the Rajoy government has failed to assuage market fears about the state of the banking system. Spanish banks have been hit hard by the burst of the house price bubble. The government is pushing them to provide for additional write-offs on loans to the real estate sector of some EUR 50 bn. In the eyes of many market participants this figure is too low. They expect higher losses due to further declines in Spanish house prices. So far, house prices are down 21% from their peak. By comparison, according to the Case/Shiller index, US house prices have decreased by 34% so far. With Spain most likely suffering from more severe over-building, it seems likely that Spanish house prices will have to fall by more than those in the US. Unfortunately, the Spanish govern-ment has not clearly explained how much more adjustment they expect for the Spanish housing market, what this implies for the banking sector, and how the government intends to deal with the consequences.
How to rebuild confidence
As explained above, a lack of confidence is in our view the biggest obstacle to economic growth and financial stability. Without confidence, companies lack the inclination to invest, domestic and foreign investors the willingness to lend, and private households the courage to tap their savings to sustain consumption. Hence, a necessary condition for economic growth is a restoration of con-fidence. To this end, policy action is required both at the country and the EU level.
At the country level, losses of confidence have been caused by doubts over the sustainability of internal and external deficits. Hence, policies to reduce these deficits are essential for rebuilding confidence. It is a fallacy to believe that eco-nomic growth, fiscal austerity, and structural reform are competing policy objectives. Rather, fiscal austerity and structural adjustment are necessary to eliminate the above-mentioned doubts that have undermined confidence. To the extent that fiscal austerity and structural adjustment rebuild confidence they promote economic growth. Of course, for policies of fiscal austerity and struct-ural reform to instill confidence they need to be sustainable. For this the elector-ate has to stand behind these policies. Like in a personal fitness programme, fiscal austerity and structural reform have to be dosed such that the programme will not be prematurely abandoned by the patient. Consequently, the challenge is to find the optimal path for austerity and adjustment and leave no doubt that it is being pursued. So far countries have not entirely succeeded in meeting this challenge.
At the EU level, losses of confidence have been caused by doubts over the effectiveness of crisis management. Much progress towards establishing a crisis management regime has been made over the last two years, but it would be mistaken to believe that enough has been done. In effect, policy makers have built a two-level support system. At the first level, the EU and IMF provide limit-ed adjustment funding against strict policy conditionality. Countries tend to resist entry into this support regime, and some countries are too big for the financial assistance available there. At the second level, the ECB provides virtually un-limited financial support without any policy conditionality through the banking system. But this regime not only allows countries to escape adjustment pressure from the markets but is also resisted by a minority of countries with lesser internal deficits and external surpluses. Hence, it remains highly doubtful that this two-level support system is capable of helping to restore EMU to stability. Similar doubts exist with regard to the intended crisis prevention regime in the form of a fiscal compact and economic policy coordination at the euro area level. Will sovereign nations indeed accept policy instructions from EU bodies over which they have no democratic control? Should the perception grow that there is a conflict between retaining democracy and the euro in Europe, it is obvious that the single currency would lose out. Rebuilding confidence in EMU at the EU level in our view therefore requires a reconciliation of the two-level support system into a consistent and coherent crisis management regime and greater reliance on the market as a force exerting disciplinary influence on national fiscal policies. As we have argued for the last two years, creation of a European Monetary Fund (EMF) and holding sovereign nations liable for their financial decisions by allowing governments to default (as was done in the case of Greece) would help achieve these objectives.
Are we getting there?
In our view, 2012 will be the decisive year for the future of the euro. Whether or not Italy and Spain pursue consistent adjustment programmes credibly and with continuity, and crisis management at the EU level is transformed from a patch-work of schemes into an effective and credible regime, will determine the financial and monetary stability of EMU in the future. A lack of economic adjust-ment and continuous monetary funding of banks and governments would raise tensions among EMU member countries to a point where the long-term survival of the euro would be in jeopardy. At present, the glass seems half full: Italy and Spain have started serious programmes of economic reform and legislation for the permanent crisis management mechanism ESM is under way. To fill it entirely, reforms in Italy and Spain will have to deliver the necessary fiscal adjustment and economic flexibility, and the ESM will have to be developed into a European Monetary Fund capable of dealing with economic adjustment funding and (in cooperation with the ECB) management of liquidity crises (see “Liquidity in times of crisis: Even the ESM needs it”, by Daniel Gros and Thomas Mayer, CEPS Policy Brief No. 265, March 2012). However, achievement of these objectives will also require the constructive cooperation of the new French government. Clearly, a sound platform for EMU cannot be developed when France is in opposition.
Differences in view between France and Germany, which has so far driven the reform agenda for EMU forward, seem to be concentrated in mainly two areas: the role of the ECB and of EU institutions in funding economic adjustment. French politicians and in fact large parts of the population tend to favour a broader mandate for the ECB that includes “growth” and a greater involvement of EU institutions in funding “growth”. Both ideas are anathema to German politicians and the majority of the population. However, a reconciliation of these positions seems possible. Development of the ESM into the EMF could assuage French fears that the ECB would pursue the objective of price stability without paying any attention to financial stability while at the same time placating German fears that the ECB would mix the two jobs in an intransparent and politically opportunistic way. Moreover, optimisation of the EU budget and the numerous EU support funds for supporting economic growth could mobilise financial resources for this objective and render politically controversial “project bonds” (i.e., bonds issued under joint and several EU liability for the funding of public investment) unnecessary.
For 2012, the EU budget totals EUR 147.2 bn. This is equivalent to 1.2% of GDP for the EU-27, but 3.5% of GDP for the group of GIIPS (Greece, Ireland, Italy, Portugal and Spain) and central European countries. About 40% of the budget is used to support agriculture, hardly a growth industry, against 6.5% of total spending devoted to supporting research and development. The budget is used to fund numerous support programmes, ranging from cohesion to structural funds, whose contribution to growth is at least questionable. Clearly, a streamlining of EU spending on regions urgently needing support for economic growth and measures most conducive to stimulating growth would be a first step before additional funding is discussed.
A number of commentators have demanded a “Marshall Fund” for the de-pressed regions of Europe. However, these commentators seem to overlook that the Marshall Programme amounted to only 2.1% of GDP of recipient count-ries and hence was smaller than the EU budget is today when related to the aggregate GDP of countries in need of support. Moreover, the advocates of a new Marshall programme fail to understand that the purpose of the original programme was to overcome a shortage of US dollar funding in post-War Europe owing to considerable current account surpluses of the US, the issuer of the reserve currency. In this regard, the original Marshall Programme was more similar to adjustment than to growth funding. As soon as the bottleneck of dollar shortage was overcome, European economies took off. What we need today, however, is support for long-term economic growth. First and foremost, this requires economic policies that create confidence for companies to invest, banks and external investors to lend, and household to reduce transitory savings undertaken as precaution for a deepening of the euro crisis. To the extent that public funding support is needed, this ought to come primarily from existing adjustment and longer-term growth financing facilities. There seems to be ample scope for making existing facilities more efficient. This scope should be exploited before new facilities are discussed.
At the root of the recession in the euro area is a lack of confidence in the ability of individual countries to achieve the necessary economic flexibility required for a monetary union of regions with divergent economic developments, and in the capability of EU institutions to manage the present crisis. The restoration of confidence is essential to end the recession and return to economic growth. The question therefore is not whether to give priority to fiscal austerity or economic growth but to find the optimal degree of austerity and structural reforms for the maximisation of confidence. In this regard, we consider the glass half full: Economic policies in Spain and Italy are going in the right direction and there has been considerable progress towards establishing a crisis management mechanism for EMU. However, much still needs to be done. Governments in Spain and Italy have to stay the course and the new government of France has to join the club of reformers. Moreover, the inconsistent two-level crisis manage-ment system has to be turned into a consistent and effective regime. In our view, 2012 will be the decisive year for the future of the euro. At present, we still see a good chance for a successful stabilisation and consolidation of EMU.
Copyright © 2012 • Deutsche Bank AG, DB Research
Published by kind permission of Thomas Mayer.