After Greece obtained its third bailout last summer, Europe turned its attention to other crises. But it would be naive to conclude that the sovereign debt crisis is over. The Greek drama is still far from a happy ending; in Portugal and Spain, fragile left-wing governments may want to abandon austerity and roll back reforms; France has declared a state of economic emergency; Italy’s competitiveness keeps declining; the European Central Bank’s interventions are getting diminishing returns at increasing risk; and Germany has switched from complacency to angst mode.
In February, the European Commission published its latest economic projections for 2016-2017. Pierre Moscovici, the European Union’s commissioner for economic affairs, noted that the economy “is successfully weathering new challenges” due to the beneficial effects of “cheap oil, the euro rate and low interest rates.” Nevertheless, he mentioned “crosswinds” that could stall the positive trend: the slowdown in China, volatile oil prices, geopolitical tensions and “policy uncertainties inside Europe.” On this last point, Mr. Moscovici was curt. He mentioned neither the migration crisis nor the United Kingdom’s possible departure from the EU as major economic risks.
Even more strangely, the full report cites extra government spending in response to terrorist threats and the refugee crisis as “positive surprises from public consumption.” In the econometric models that underlie the EU forecasts, these outlays count as “demand-driven” stimuli to the economy.
This confidence seems misplaced. It is clear that most of the refugees who have made it to Germany and Sweden, let alone those stranded in Greece and Italy, will not be integrated into local labor markets and creating added value anytime soon. Meanwhile, a side effect of uncoordinated refugee flows across Europe has been the reinstatement of border controls in several countries. If borders within the Schengen area are closed, the economic costs will be significant. A French think tank estimates the costs of freight and travel delays, along with reduced tourism, will amount to 110 billion euros over the next 10 years.
The European Commission forecasts the euro area economy will expand at a rate of 1.7 percent this year and 1.9 percent in 2017 – slightly slower than the EU as a whole and barely half the rate of the world economy, which is projected to grow by 3.3 percent and 3.5 percent, respectively. Europe’s growth engines will be Poland, where gross domestic product is seen expanding by 3.5 percent in 2016 and 2017, along with Spain, the UK and the Netherlands, which are all expected to grow faster than 2 percent. Germany is seen below the EU average at 1.8 percent in both years.
Greece is expected to do better than previously expected this year, posting a contraction of only 0.7 percent. The country should rebound in 2017 with solid GDP growth of 2.7 percent, its best performance in a decade, according to the EU forecasts.
However, “policy uncertainties” abound in Greece. Brussels expects Athens to run budget deficits this year and next. The country’s debt-to-GDP ratio is expected to peak this year at 185 percent before declining to 182 percent in 2017. Capital controls remain in place to prevent bank runs and capital flight. Border controls have proved less effective, as thousands of refugees continue to brave the Aegean Sea to land on Greek islands.
Meanwhile, Greece and its public creditors remain at odds over an assessment of bailout measures needed to unlock new financial aid. There is still no agreement on extremely unpopular pension cuts that have yet to win approval from lawmakers. Athens wants to conclude the review swiftly to start talks on debt relief. This is also what the International Monetary Fund (IMF) wants, because it sees no other way the country’s finances can be put on a sustainable basis. But the IMF is not convinced the Greeks have done enough to curb spending, and has delayed any decision on whether to participate in a third bailout until the second quarter.
The IMF’s continued involvement was a key argument for the German government to win approval of the Greek bailout package. Berlin believes that if EU institutions alone represent Greece’s creditors, they will be too lenient. On the other hand, there is great reluctance in the German government to take the IMF’s advice and grant Athens substantial debt relief, since any “haircut” would seriously affect German taxpayers.
In short, a lot could still go wrong in Greece. The Syriza government is fragile and under intense financial and political pressure. “Grexit” could still be a possibility in the near future, as a top IMF official recently warned.
Other crosswinds are likely to build up in the southern members of the eurozone. While the European Commission expects strong growth from Spain, it also mentions “downside risks” stemming from the country’s inability to form a government since the inconclusive December 2015 elections. Despite coming first with close to 29 percent of the vote, acting Prime Minister Mariano Rajoy’s conservative Popular Party (PP) lacks coalition partners.
Socialist (PSOE) leader Pedro Sanchez has been in talks with the left-wing populist Podemos movement and smaller communist and secessionist parties on a possible government. While many issues divide these parties, they are united on ending austerity and pro-market reforms – precisely what Brussels believes is needed to keep Spain from becoming a problem child in the eurozone.
Portugal is similar to Spain in key respects. Its conservative reform government lost its majority in October 2015 and, after weeks of uncertainty, was succeeded by a minority socialist cabinet. The new government holds power thanks to support from the anti-euro Communist Party and the radical Left Bloc, both of which reject any more austerity. The terms of the country’s 78 billion euro bailout require it to present draft budgets to the European Commission. Following an extended tug-of-war, Portugal received conditional approval for this year’s budget, with Commissioner Moscovici warning that Portugal was at risk of non-compliance with EU fiscal rules and would require careful monitoring.
Left-wing governments in France and Italy never wholeheartedly subscribed to austerity and pro-market reforms, to say the least. In contrast to their counterparts in Greece, Spain and Portugal, incumbent cabinets in Paris and Rome look set to survive until the next elections (May 2017 in France, May 2018 in Italy.) Since these countries are the second and third largest economies in the eurozone, however, even smaller political risks carry much more weight.
The European Commission expects growth in France and Italy to lag behind the euro area average in 2016 and 2017. France is projected to violate the EU budget deficit limit of 3 percent of GDP in both years, as it has done continuously since 2008. Despite Mr. Moscovici’s warning that the Commission will not accept further non-compliance with deficit reduction, French President Francois Hollande recently declared a “state of economic emergency” and announced a 2 billion euro spending program. Faced with 26 percent youth unemployment, Paris now wants to subsidize hiring young or unemployed people and to create more than 500,000 vocational training positions.
Commissioner Moscovici has also been tested by the Italians. After recent rants by the Italian prime minister against pettifogging bureaucrats in Brussels and Berlin, Mr. Moscovici said he expected “serenity, patience and capacity for dialogue” from the authorities in Rome.
In January, Italy reached an agreement with the EU on the bad loans plaguing its banks. Non-performing loans had grown from 125 billion euros in 2012 to 201 billion euros in 2015 (only Greek banks had a higher share of non-performing loans). The deal was the first official test of the eurozone’s new rules for bank resolutions and bail-ins, making it a precedent-setter.
Italian banks will be allowed to package their bad loans into securities and then sell them off to private investors. The Italian state will facilitate this by guaranteeing the senior tranches of these securitizations. This clearly suggests there are risks involved that few market participants would be willing to bear. While the plan tries to work within EU rules on state aid, it does not really meet the banking union principle that investors and not taxpayers should bear the burden.
But Italy has more to worry about. After many years of recession, real GDP per capita is still lower than in 1999. Labor productivity continues to decline, without being offset by any reduction in labor costs. Taxes and regulations keep firms from growing. This all suggests Prime Minister Matteo Renzi’s government needs to move swiftly ahead with economic and institutional reforms.
Over the past few years, the European Central Bank has become a key factor in the calculations of market players and politicians alike. An initially reluctant and now fully committed lender of last resort, the ECB is arguably more powerful than national governments in preventing a breakdown of the eurozone.
However, for reasons explained in other GIS reports, quantitative easing (QE) has had little effect on real investment. Most of the cheap new money is being used by banks to roll over bad loans or to fuel new asset price bubbles in stocks, bonds and real estate. Massive buying of government bonds has reduced governments’ incentives to reform. In buying time, the ECB has also helped delay needed restructuring of banks, businesses and the political system.
Prime Minister David Cameron will hold a referendum on the UK’s continued membership in the