Europe's Debt Crisis Continues to Simmer

Article
Summary
The relative calm in Europe signals a pause in—not an end to—the debt crisis. Though policy makers have taken encouraging initial steps to close budget deficits and restore competitiveness, much more remains to be done.
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Despite posting impressive GDP growth in the second quarter, Europe still faces highly uncertain economic prospects. Germany’s recent performance is encouraging, but the Euro area—and the economies at the center of the debt crisis in particular—continue to languish. Though these countries have made efforts to close budget deficits and restore competitiveness, much remains to be done and optimistic forecasts by officials cloud the full extent of their problems. From a global perspective, the situation in Italy, the world’s eighth largest economy, is particularly worrisome.

One Quarter Does Not a Recovery Make

In the second quarter, the Euro area’s economy grew by 3.9 percent (q/q, annualized), the second fastest rate since 2001. The strong bounce, however, reflects how deeply Europe has fallen: GDP in the Euro area remains 3.5 percent below its 2008 level, compared to only 1 percent in the United States, despite the recent spate of poor data there. Even after posting record growth of 9 percent (q/q, annualized), Germany also lags behind the United States.

The relative calm in Europe signals a pause in—not an end to—the debt crisis. Though policy makers have taken encouraging initial steps to close budget deficits and restore competitiveness, much more remains to be done.

Recent data suggests that, though growth will almost certainly slow from its high pace, momentum in both Europe overall and Germany in particular should be at least partially maintained. August indicators of European and German economic confidence are promising, and German unemployment is now 0.8 percentage points below its June 2009 high of 7.7 percent.

Overcoming the Debt Crisis

However, Europe’s problems were never in Germany, but in the periphery—Greece, Ireland, Italy, Portugal, and Spain (GIIPS)—which is still hurting. Growth in the GIIPS has stagnated since the outbreak of the Great Recession, and their output has decoupled from that of the European core (Austria, Belgium, France, Germany, and the Netherlands).

The relative calm in Europe signals a pause in—not an end to—the debt crisis. Though policy makers have taken encouraging initial steps to close budget deficits and restore competitiveness, much more remains to be done.

A protracted slowdown in the GIIPS countries was expected given their need to contain demand and reduce fiscal deficits. In the longer term, however, these policies must also restore competitiveness. They have certainly done the former—GDP in the GIIPS countries has contracted by 0.2 percent since the first quarter of 2009—but are they setting the stage for the latter?

Government Finances

According to the IMF, Greece, Ireland, and Spain are on track to fully or nearly meet their deficit targets for 2010, but slower-than-expected growth could undermine longer-term goals. Greece’s economy contracted by an EU-low of -5.9 percent (q/q, annualized) in the second quarter, and the IMF already doubts the feasibility of the official medium-term deficit targets in Spain, Italy, and Ireland

European Central Bank (ECB) support provisions have largely stabilized teetering banks. Stress tests partially restored confidence in the banking sector, and consolidation and capital increases are also helping—in Spain, for example, savings banks responsible for managing 92 percent of the sector’s assets have been involved in mergers.

The relative calm in Europe signals a pause in—not an end to—the debt crisis. Though policy makers have taken encouraging initial steps to close budget deficits and restore competitiveness, much more remains to be done.

Irish banks, however, continue to weigh on public-sector finances. These banks face a surge in refinancing costs this month—funds that will be even more difficult to raise after S&P’s recent downgrade of Ireland’s credit rating—and the government’s guarantee of short-term bank debt requires that taxpayers pick up whatever tab remains. Already, officials estimate that supporting the bank Anglo Irish could cost 25 billion euros, or a staggering 15 percent of GDP. 

Despite government commitments to rein in deficits, markets remain skeptical. As of September 15, ten-year bond spreads against the German bund are higher than their crisis peaks on May 7 in Spain and Ireland; in Greece, Portugal, and Italy, spreads have come down only slightly. Given the impressive array of measures put in place to contain the problems—including the 750 billion euro joint EU-IMF support package and ECB commitments to buy government bonds as well as to lend against lower-rated collateral—the continued market anxiety highlights the severity of the crisis.

Competitiveness

Though government debt was at the center of the crisis that erupted in the spring, the root cause was the loss of competitiveness by GIIPS countries. Restoring competitiveness will require, among other things, labor market reforms and wage adjustments, and will take a long time.

Initial reforms have been encouraging, particularly in Greece, Ireland, and Spain. Policy makers in Greece have already quelled a strike by truckers, and additional reforms are expected by the end of the year. Ireland took important steps early on, slashing public sector pay in late 2009. In June of this year, Spain approved a range of reforms aimed at increasing labor market flexibility.

Low inflation in Germany is undermining progress, however, as wages and prices in the GIIPS countries must fall relative to international ones—including those in Germany—if competitiveness is to be restored.1 Only Ireland has maintained an inflation rate well below that of Germany. Spain and Portugal have made moderate adjustments, while relative prices in Greece and Italy continue to climb. 

The relative calm in Europe signals a pause in—not an end to—the debt crisis. Though policy makers have taken encouraging initial steps to close budget deficits and restore competitiveness, much more remains to be done.

ECB calculations of competitiveness similarly find that competitiveness in all of the GIIPS countries against major global trading partners has improved since the nadir of the Great Recession in March 2009—primarily reflecting the euro’s devaluation—but that only Ireland has improved against Germany. Trade balances confirm these modest improvements: exports grew faster than imports in the first five months of 2010 (y/y) in each of the GIIPS countries except Italy.

More Aggressive Policy Measures Still Needed

The Core Countries

With weaknesses rampant in southern Europe and growth slowing in the United States and China, policy makers in Europe’s core have little room for complacency after just one quarter of impressive growth—especially one that relied heavily on exports.2 Domestic demand—which includes government spending—must now drive the core’s recovery.

Core economies should also consider allowing larger wage increases and more expansionary monetary policy. The latter would not only bolster the core’s recovery efforts, but would also ease the adjustment in the GIIPS countries. For example, despite averaging inflation of 1.6 percent in 2010—below the typical advanced economy target of 2 percent—Italy continues to lose competitiveness against Germany, where inflation has averaged 0.6 percent.

The GIIPS Countries

Continued efforts to reduce deficits are needed. Given the limits on how sharply they can reduce spending, governments will need to expand their tax bases to trim their deficits. Because missed budget targets could spark another bout of market anxiety, officials should be conservative when setting deficit reduction goals.

Reducing debt levels, especially when borrowing rates are elevated, will eventually require a resumption of growth—underscoring the importance of structural reforms. Given the considerable distortions in markets across the GIIPS countries, reform efforts could yield impressive results. Though progress varies across countries, reducing wage indexation, liberalizing closed professions, and reforming pension systems are untapped areas for change in many instances. Needless to say, these reforms will require political courage.

Without urgent reforms, another decade of anemic growth may be the best scenario Italians can hope for.

The situation in Italy, the world’s eighth largest economy, is particularly worrisome. Italy was not the country hurt most by the crisis—its deficit rose to “only” 5.3 percent of GDP in 2009—but Italian leaders in the governing coalition are embroiled in a power struggle and have responded too timidly to meet the country’s new economic challenges. Despite years of stagnation and falling productivity before the crisis, Italy is making only gradual improvements in competitiveness, lagging behind those in Germany. Current account deficits are growing again. And little is being done to reform inflexible labor markets.

For both Italy and the world economy, the stakes are high. In 2009, Italy’s public debt rose to 116 percent of GDP, or nearly $2.5 trillion. Hopefully, a rescue of Italy—which would be beyond the current capacity of the IMF and the EU—will not be necessary. Still, leaders have planned only small budget cuts based on optimistic growth forecasts of 2 percent a year—nearly twice the recent average—and, without urgent reforms, another decade of anemic growth may be the best scenario Italians can hope for.

Bennett Stancil is a researcher in Carnegie’s International Economics Program.


1. In the absence of currency depreciation, prices in the GIIPS must fall relative to those in Germany in order to restore competitiveness vis-à-vis Euro area trading partners. Wage reductions can also increase competitiveness, and despite wages being subject to deliberative means of adjustment—governments have cut or frozen wages across the GIIPS—downward nominal wage rigidity makes economy-wide reductions extremely difficult. Furthermore, inflation tends to lead wage growth, suggesting that higher inflation could point to nominal wage increases. 

2. More than one-third of the German expansion was due to export growth, and early reports already point to a marked slowdown.

End of document

About the International Economics Program

The Carnegie International Economics Program monitors and analyzes short- and long-term trends in the global economy, including macroeconomic developments, trade, commodities, and capital flows, drawing out their policy implications. The current focus of the program is the global financial crisis and its related policy issues. The program also examines the ramifications of the rising weight of developing countries in the global economy among other areas of research.

 
 
Source http://carnegieendowment.org/ieb/2010/09/16/europe-s-debt-crisis-continues-to-simmer/2rl0

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