7/28/2010
Is Europe's Recovery still on Track ? Prof.Andrea Boltho, REAG's European Advisory Board
Growth in Europe (and in the world economy) has continued. GDP expanded in the first quarter of this year and is expected to have done so in the second. Prospects for the rest of 2010 remain moderately favourable. Both business surveys and forward looking indicators suggest that the pace of growth may slow down, but should not turn flat or negative. The same would seem to be broadly true for the United States.
GDP Growth Rates (%)
| | 2008 | 2009 | 2010 | 2011 | 2012 |
Eurozone | 0,5 | -4,1 | 0,8 | 1,3 | 1,9 |
United Kingdom | -0,1 | -4,9 | 1,1 | 2,1 | 2,7 |
United States | 0,4 | -2,4 | 3,1 | 3,3 | 3,3 |
China | 9,6 | 9,1 | 9,4 | 9,1 | 8,9 |
World | 1,6 | -1,9 | 3,5 | 3,6 | 4,0 |
Yet, there are still many uncertainties in this picture. If anything, the risks to the outlook, both in the short- and in the medium-term may have increased. One worrying sign has been the weakness of some recent indicators in the United States. Despite unprecedented fiscal and monetary stimulus and despite a vigorous recovery until now, employment and consumption growth in recent months have flattened out while price pressures are diminishing. One specific problem is retrenchment at local government level. While the federal authorities are still able to spend, 49 out of the 50 States are bound by their constitutions to run balanced budgets. As tax revenues have shrunk, this is forcing many of the States into deep expenditure cuts, with inevitably negative effects on employment.
A more subdued American economy would inevitably also weaken Europe, both through direct effects on demand and indirect effects on confidence. In addition, Europe's continuing recovery will have to rely increasingly on private consumption and investment. Fiscal stimulus is being withdrawn and the rebuilding of stocks is unlikely to continue for long. Yet, the outlook for private consumption is uncertain in view of the high levels of both household debt and unemployment (bar in Germany). As for investment, this would seem to be constrained not so much by finance (corporate cash flow is relatively abundant), but by uncertain demand prospects and large margins of spare capacity. Exports to non-OECD countries are relatively buoyant (especially in Germany), but the level of the Euro, which had fallen sharply for a few months, has recently recovered thereby denting a hoped for improvement in external competitiveness.
In addition to these short-term uncertainties, the medium-term outlook has also worsened, largely in response to the Greek sovereign debt crisis. There are two aspects to this. On the one hand has come the realisation that Greece may well have to restructure its public debt, which would otherwise reach unsustainable levels. On the other has come the fear that, given its very low level of competitiveness, the country may be forced out of (or may chose to leave) the Euro area, if it wanted to avoid years and years of slow growth. If either of these two events materialized, there would be a clear danger of contagion to other relatively weak European countries - Portugal springs to mind, but Ireland, Spain or even Italy could also be in danger since they all suffer, if to different degrees, from either high public sector debt levels and/or low external competitiveness.
Largely in consequence, European governments (including some that are not even members of the Euro zone, such as the British and Danish ones), have embarked on what looks like an unprecedented cure of austerity. In country after country, medium-term budgetary plans have been approved (or are under active discussion) that foresee drastic cuts in expenditures and/or rises in taxation. In the Euro area the aim is to return to budget deficit/GDP ratios not much above, or ideally below, the Growth and Stability Pact's 3 per cent figure. Germany (which seems hardly threatened by fears of domestic, let alone external, bankruptcy) has an even more ambitious aim of returning to a virtually balanced budget by 2016.
There is a clear danger that such restrictive policies, if fully enacted, could significantly weaken many economies over the medium term. As it is, the recovery that was forecast this spring, before the new policies were announced, was only modest. Additional rigour could well nip it in the bud, as fiscal retrenchment raises unemployment and reduces demand. The example of Japan in 1995 is often cited: at the time a timid recovery was aborted by an ill-conceived increase in indirect taxation. Proponents of fiscal austerity (e.g. Angela Merkel or Jean-Claude Trichet) argue forcefully that such fears are unfounded. According to them, private demand may well be stimulated by cuts in public expenditure. At present demand is weak because the private sector, seeing large deficits and high debt levels far into the future, lacks confidence. As the government puts its accounts in order, confidence will return and demand will revive. Plenty of examples exist, it is argued, that show how severe fiscal retrenchment, far from leading countries into recession, had positive effects on economic growth.
It is indeed true that a number of OECD economies did in the 1980s and 1990s pursue successful fiscal consolidation, yet went on growing at very satisfactory rates. The examples of Australia, Canada, Denmark, Finland, Ireland or Sweden are often cited in this context. What is forgotten, however, is that growth in these countries was powerfully helped not so much by a revival of private sector confidence, as by significant declines in long-term interest rates and/or in real exchange rates. Unfortunately neither of these two remedies is feasible in present circumstances. Interest rates are already at very low levels and can hardly be expected to decline further. As for exchange rate depreciation, this is feasible for one small open economy at a time; it is not, or hardly, for the whole of Europe except, possibly, vis-à-vis the dollar and the yuan (and both currencies may well try to resist such a move).
In other words, short-run uncertainties could give rise to a W shaped recovery (even if the second leg of such a W profile would almost certainly be much shallower), while the rush to reduce deficits and debt could condemn Europe to several years of slow growth over the medium term.
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