Olli Rehn, the European Commission’s vice-president for economic and monetary affairs told reporters that “growth has stalled in Europe, and there is a risk of a new recession.” In Portugal, Europe expects economic contraction to hit 3%, even more pessimistic than the government’s own projections. The press is buzzing about this because it adds urgency to getting the sovereign debt crisis sorted.
But Rehn understates the issue. Europe is already in recession. Euro zone factory data released earlier this month made this clear. Moreover, the policy remedy chosen by Europe to deal with the sovereign debt crisis, fiscal adjustment in the periphery without any countervailing stimulus in the core, only makes the likelihood of missing deficit targets greater.
Deficit slippage alone will keep bond yields in the periphery elevated. In fact, these elevated yields in the periphery have caused contagion to the core as Belgian and French spreads to German yields were at or near record highs yesterday. The elevated yields in France, in turn, have caused France to conduct its own round of budget cutting as well.
The bottom line is that this is a very deflationary outcome. Recession causes high deficits, which are met with government budget cuts. The loss of output from budget cuts begets more recession and lost output, which must then be met with more budget cuts. Meanwhile the deficit slippage makes investors skittish, sending bond yields higher and making the deficit targets even harder to reach.
Europe is in a policy cul de sac right now. The goal is to right the ship by getting government spending in line with the Maastricht criteria, without killing demand, exacerbating recession and precipitating a debt deflation. In this case, cuts in the periphery must be offset by a massive currency devaluation and/or additional consumption in Germany. The Germans are simply not willing to sacrifice their budgetary discipline, especially given the now deteriorating economic and budgetary outlook. Nor can German consumers make up for the massive cutting and contraction, if France and Italy, the second and third largest euro zone countries are cutting and reducing demand too.
No wonder policy makers are now talking about how to end the euro. We have to get over the hump before that happens, of course. The liquidity crisis in Italy is still the pressing problem. Because the ECB decided to monetise yet more Italian debt today, Italian yields have backed down. It is clear that short of more ECB interventions, Italian yields will remain elevated. And the ECB cannot buy up bonds forever; it is politically unsustainable.
So I continue to predict that Europe will make an unlimited commitment to Spanish and Italian bonds as a lender of last resort. It is cheaper as the ECB will not have to buy bonds if it is credible. I also continue to expect Europe to move to change its constitution to include greater fiscal integration, but also to include explicit mechanisms for countries to leave the euro area. The Maastricht Treaty and the Lisbon Treaty clearly state that the goal is to “ensure closer coordination of economic policies and sustained convergence of the economic performances of the Member States”. This convergence has not come to pass and so now we are in a major crisis. It is becoming increasingly clear that convergence will never happen. The euro zone is unworkable. It needs tighter fiscal integration to succeed and it can’t have that unless it gets convergence. The Europeans are starting to recognize this and so breakup is now inevitable.
P.S. – I don’t think the breakup would happen straight away because we are in a crisis and a breakup now would also lead to a significant economic Depression. But once the situation is stabilised, thoughts will turn to these issues.