Against the tide: Credits and debits
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Against the tide: Credits and debits

In the ledger of economic recovery, reasons to be optimistic are neatly balanced by reasons to be pessimistic.

Right now, the investment world is like a giant T-account, with every credit of optimism balanced by a destructive debit waiting to happen. Equity markets continue to surge to new highs on the back of improving economic data in the US and a potential manufacturing-led global economic recovery. But against this must be balanced the possibility of a fiscal squeeze on US economic growth if sequester cuts in spending are fully implemented. And a bottoming of the recession in Europe and improving intra-eurozone imbalances must be measured against a risk of a renewed euro crisis coming out of Italy, Spain or Cyprus.

Optimism on Europe rests on improving business activity surveys, which have increased confidence that the eurozone is finally stabilizing. Behind that lies the more fundamental credit of market reforms and austerity leading to some impressive improvements in the competitiveness and imbalances of the reforming peripheral countries. That means Portugal, Ireland and, to a lesser extent, Spain and even Greece.


But behind those happy credits lie dark debits. There is no eurozone growth in sight that would make peripheral debt sustainable. European Central Bank funding of eurozone banking has thickened the umbilical cord between the banks and the sovereigns, as Cyprus shows. The banks used the improved liquidity not to lend to the real economy but to increase their stakes in government debt. That is the opposite of the policy goal of severing the sovereign-bank nexus that was sought.

Italy now lies at the centre of potential crisis. The country is an unreformed morass heading for political paralysis. Any new government might hold the line on the budget deficit for a while, like a cartoon character peddling in the air after stepping over the cliff edge. But Italy’s sovereign debt is unsustainable without growth, and growth is unachievable without reform.

Spain is in better shape, but is still a long way from achieving the growth that would stabilize its debt burden. Market reforms are working only gradually towards making the real economy more competitive. The fall in Spanish unit labour costs so far is predominantly the result of people losing their jobs. Up to now wages have not reacted much to labour market slack. In the private sector they have even continued to rise. The new liberalized system of setting wages at the enterprise level only comes into force as old collective wage agreements expire. The rollover will take several years. But it will ultimately result in a falling trend of wages, albeit way later than the more radical reforming economies of the periphery. For now, losses in employment have to bear the brunt of adjustment. Consequently, Spain’s current productivity gain is overly dependent on high output gaps.

Eurozone relative unit labour costs Q1 2002 = 100

Lack of growth means that Spain’s budget target was missed for last year and will be again this year. It doesn’t take a genius to see that once the EU blesses the revised budget targets, theoretically Spain could apply for a bailout programme. But it is unlikely the Spanish will do so unless markets turn against them. And then there is Cyprus. The Eurogroup bail-out package for Cyprus was bad on three accounts. It was inadequate, it was unfair and it was unethical. Therefore, it would not work. And a dangerous precedent has been set for depositors in other EU countries. Acting late and acting inadequately is par for the course throughout the eurozone crisis. There has been little vision and no pre-emptive action from the EU’s woeful political leadership.


Complacency is the political debit of the current surge of market optimism. Germany has turned inwards to deal with its own election. So no new euro policies will emerge until after that. There is backtracking on ESM direct financing of the banks without recourse to the sovereign. A single EU bank resolution mechanism and deposit insurance scheme are becoming much longer-term goals and shrinking in scale as they retreat to the distant horizon.

The ultimate Manichaean battle for the euro is the confrontation of France and Germany over the political and economic architecture of the European project: federal versus national government; state-dominated versus market economy. The two visions are irreconcilable within a single currency where both countries are dominant players. France’s deteriorating economy will mean it will fail to meet its fiscal commitments under the new EMU treaty. This will be clear after the German federal elections in the autumn. Then the real battle will begin.

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