Summary: Despite Europe’s continual moving of the goalposts to give countries more breathing room, the economic paradigm in Europe is still the same: austerity. This will dampen growth in Europe for the foreseeable future and increase government debt to GDP ratios, making debt deflation and crisis a background threat which will eventually result in sovereign restructurings regardless of recovery. I expect Greece to be on the table in 2014.
A lot of hay has been made about the recovery in Europe despite its fragile beginnings. Certainly, I called for the recovery early because the second derivative numbers in Europe were improving. Nevertheless, we need to be cautious here because growth in and of itself does not mean recovery. And the term recovery itself does not necessarily connote normalcy.
Recovery is a technical term which basically means the economy is growing across a broad range of indicators. In the US, the National Bureau of Economic Research dates business cycles and explains how it determines those dates. The NBER’s business cycle dating has become the accepted standard in the U.S.. The NBER Dating Committee explains its work as follows:
The Committee does not have a fixed definition of economic activity. It examines and compares the behavior of various measures of broad activity: real GDP measured on the product and income sides, economy-wide employment, and real income. The Committee also may consider indicators that do not cover the entire economy, such as real sales and the Federal Reserve’s index of industrial production (IP). The Committee’s use of these indicators in conjunction with the broad measures recognizes the issue of double-counting of sectors included in both those indicators and the broad measures. Still, a well-defined peak or trough in real sales or IP might help to determine the overall peak or trough dates, particularly if the economy-wide indicators are in conflict or do not have well-defined peaks or troughs.
So a recession is not two quarters of GDP as the false commonly-used shorthand in the media goes. A recession is simply a period in which economic activity declines substantially as measured across a broad range of economic data. that includes real GDP, employment and income. Analogously then, an economic recovery is a period in which economic activity increases substantially across a broad range of economic data.
Are we there yet in Europe? I would say no though I believe we will get there. The Centre for Economic Policy Research puts this well:
“”While it is possible that the recession ended, neither the length nor the strength of the recovery is sufficient, as of 9 October 2013, to declare that the euro area has come out of recession,” the committee said. The committee said that for it to conclude that the euro zone had emerged from recession, it would have to see “evidence of sustained growth, corroborated by a range of indicators.” Eurostat will publish GDP figures for the third quarter on Nov. 14. While business surveys suggest the economy continued to grow in the three months to September, official figures for industrial production are less clear, while unemployment remains close to record highs. “
Let’s also remember that the term ‘economic recovery’ has nothing to do with a country’s potential output in terms of labor or capital. After all, in the United States during the Great Depression, the first economic recovery began in March 1933 when unemployment was running at 25%. In fact, because recovery comes at business cycle troughs, economic recovery always occurs when the economic data are worst.
This is my long-winded way of saying that the term recovery is very misunderstood. It does not mean that an economy is firing on all cylinders. It simply means the economy has stopped contracting.
In Europe, we are almost there. However, the economic paradigm will hinder the recovery. For example, the IMF is on record admitting that austerity as practiced in Europe excessively retarded growth. See Olivier Blanchard’s May 2013 piece on why Europe is moving to backloading austerity. The EU has joined the IMF in this regard, with a recent paper by an EU economist backing austerity’s critics. But Europe has no choice. The countries in the euro zone have given up monetary sovereignty and are at the mercy of bond markets to fund their deficit spending. If government takes in less revenue than it spends, it must accept whatever price the market gives it to borrow to make up that shortfall. For Greece, right now that price is an unbearable 4% for just 3-month paper.
However, even outside of the euro zone, governments are engaged in fiscal tightening, ostensibly because they want to join the euro, must borrow in foreign currency or are afriad of the economic consequences of excessive deficits. Here are a few examples:
- Spain-regions. The regional governments have joined the federal government in tightening. Spanish local governments have reduced outlays by 13% since 2009, 2.2% of GDP. And this austerity is expected to continue. Local governments are expected to end 2014 with a deficit of 1% of GDP according to targets set by Brussels. (El País)
- Spain-federal. “The budget highlights the huge imbalances created by five years of economic crisis: Spain will set aside €36.6 billion ($49.5 billion) to service its fast-rising pile of public debt, €2 billion more than it will spend on the 13 government ministries. And it is pledging about €31 billion for welfare and entitlements, up almost 20% from last year. That includes unemployment benefits for the more than a quarter of the working population that is registered as out of work.” (WSJ)
- Portugal. “Lisbon has unveiled a tough austerity budget for 2014 that is seen as a crucial step in government efforts to avert the need for a second bailout when Portugal’s €78bn rescue programme ends in June. The proposals, including cuts of up to 12 per cent in public sector pay, are partly aimed at building investor confidence and preparing the way for Lisbon to return to international capital markets this year or early in 2014.” (FT)
- Ireland. “Pensioners and young unemployed asked to shoulder burden of yet another austerity budget, with cuts totalling €2.5bn” (Guardian)
- Serbia “has announced plans to cut public sector wages by as much as a quarter, as part of wide-ranging austerity measures. The reform package also includes raising taxes and slashing subsidies for loss-making companies. Finance Minister Lazar Krstic said Serbia would be bankrupt within two years if it did not take action now.” (BBC)
- Finland: “A fervent defender of eurozone austerity even in the midst of its third recession since the start of the financial crisis, Finland appears to be softening its image as being more German than the Germans in the face of growing support for “populist” eurosceptic parties ahead of next year’s European parliamentary elections.” (FT)
- Netherlands. “The Dutch government reached a deal on an austerity package for 2014 in a bid to meet European Union budget requirements despite fierce resistance to more belt-tightening at home and concerns that it could further harm the already struggling economy. The coalition government struck a deal on €6 billion ($8 billion) in tax increases and spending cuts, Finance Minister Jeroen Dijsselbloem said Tuesday.” (WSJ)
Let’s remember what the IMF and EU economists have said, that initial round of front-loaded austerity in Europe resulted in unusually high fiscal multipliers which caused countries to miss targets. When these countries have missed, rather than move away from austerity altogether, the targets have simply been moved back. We should expect this to continue. Portugal is instructive here because it wants to exit the ESM-led bailout program next year and needs to cut deficits in order to garner market access in order to do so. But look at the results of its previous austerity. Early this month, the EU told us that Portugal ‘passed’ its latest bailout test. Here’s the BBC:
Representatives from the International Monetary Fund, the European Commission and the European Central Bank have approved Portugal’s economic progress. A programme of cuts and reforms was promised by Portugal’s leaders in return for its May 2011 bailout. The latest visit from the so-called troika means the next instalment of bailout funds will be granted. But the government has been unable to persuade the lenders to ease the target for next year’s budget deficit. “The programme remains broadly on track,” the troika said in a statement. “Provided the authorities persevere with steadfast programme implementation, euro area member states have declared they stand ready to support Portugal until full market access is regained.”
From the press reports and the EU statements, one would think that Portugal met its bailout targets. It did not – not even close. German-language Spiegel noted at that same time that the deficit goal for 2013 was 5.5% of GDP in Portugal whereas the actual deficit for the first half of the year was much higher at 7.1% (link in German).
My conclusion from the data and these anecdotes is that austerity will continue in a backloaded form and that this will retard growth in Europe. Moreover, looking at the debt trajectories in Europe, it is clear that they are unsustainable in the periphery. In Greece for example, despite the move toward a primary surplus, government debt to GDP is rising at an alarming rate. The economy is contracting and high interest costs are creating deficits such that the debt burden rose from 160.5% of GDP in Q1 2013 to 169.1% in Q2 , according to the latest figures available. As we speak, the debt burden is probably above 175% of GDP. This is clearly unsustainable and I fully expect Greece’s debt to be restructured yet again in 2014 after the German governing coalition has been formed and Germany can weigh in on the issue.
Elsewhere in the periphery, we see that Portugal now had a debt burden of 131.3% as of Q2, while its deficit was 7.1% of GDP. That tells you that Portugal is also on an unsustainable upward trajectory. At the present rate, we will see debt to GDP of 150% by 2016. I would be surprised if they were able to get the kind of bond market access they need to exit the international bailout program next year. More likely, the deficits will continue to miss targets and the debt will climb to levels that cause the market to believe another restructuring is coming. This belief alone will keep Portuguese sovereign bond yields elevated and force the restructuring.
Italy is a special case as a large economy within the euro zone. At this juncture, a sovereign restructuring is unfathomable. It would be catastrophic for Europe and will be avoided at all costs, even if that means some sort of ECB-led OMT-style program. The euro zone would break up first if an Italian default were on the table. With Spain, I have similar thoughts. However, their debt burden is more comparable to France’s. And Spain has tentatively started to grow. Thus Spain is not in the danger zone quite yet in my view.
Ireland can pull through because off economic growth. However, if an exogenous shock hits Europe the country’s 125.7% government debt to GDP will become more problematic. We should note that this is the level Belgium had when it went into the euro zone. So a recession with government debt at that level is not necessarily something which would trigger market panic.
One last note of caution: the change in change numbers in Europe are now neutral to negative where they had been favourable. The data flow shows a stalling in the rebound in Europe, particularly in Germany. The euro is also vaulting higher against the dollar and is at two-year highs by this measure. I still believe Europe will continue in recovery mode, but this is a fragile upturn that an exogenous shock can easily bring to a halt.