The Eurozone Crisis Isn’t Over: Spending Can End It

Euro in Crisis

There is a simple explanation for the Eurozone Crisis and an equally simple explanation for why it isn’t over. The Eurozone accounts for 7% of the world population, 25% of world output, and 50% of the world’s social expenditure. This is fiscally unsustainable. With the Eurozone growing by 0.3% in Q2 2013, there was widespread promulgations of an end to a record 18 months of recession for the 17-country union. Yet, the overall figure masks the mixed economics of the various countries, whilst the growth figure remains low.

Eurozone Members

Economic data is still bleak. Unemployment is 29% in Greece, 24% in Spain, 18% in Portugal, 15% in Ireland, 10% in Italy, and 8% in the UK. Meanwhile Greece, Italy, Portugal and Spain are struggling to balance their current accounts, especially when one considers the immense bailouts they shoulder. Ireland has received a EUR58 billion bailout, Greece has received EUR150 billion, Portugal has received EUR62 billion, and Spain has received EUR100 billion. In the Eurozone as a whole, government debt as percentage of GDP widened in Q1 2013 to the already high level of 92.2%, with government debt 130.3% in Italy, 91.9% in France, and 88.2% in Spain. Meanwhile Markit data on France in revealed economic activity continued to contract in July with its composite PMI at 48.8 due to a lagging services sector. Any figure above 50 for a composite PMI evidences growth. France has also experienced 26 continuous months of workers applying for unemployment benefits. Most importantly, before Q2 2013 the Eurozone had yet to record any quarterly GDP growth since Q3 2011 and is still forecasted to remain in recession for a second consecutive year.

Do the Best Things Come in Threes?

Europe still hasn’t sorted out its problems with its banks. There are far too high levels of debt in the European economy, which is patently obvious in their banks’ massive balance sheets and the fact that banking assets in Europe are valued at EUR32 trillion, or three times the Eurozone’s GDP per annum. In order to comply with the new Basel III regulations on capital and leverage that will come into force in 2018, Europe’s banks need to remove EUR3.2 trillion of assets and generate EUR47 billion of fresh capital. Europe’s banks have already shrunk their balance sheets by EUR2.9 trillion since May 2012. However, this is not easy as banks are also not obtaining enough new capital to write-down the many non-performing loans they have on their balance sheets. Moreover, banks are cutting assets by renewing fewer loans, repurchase and derivative contracts and selling non-core businesses (i.e. RBS is attempting to sell around 360 of their branches and Barclays sold Barclays Global Investors to Blackrock). The banks most in need of fresh capital are Deutsche Bank, Barclays and Credit Agricole. Basel III regulations are aimed at increasing banks’ capital reserves and decrease their balance sheet debt in order to avert another calamitous burden on taxpayers due to government bailouts of financial institutions. Whilst it is imperative for banks to deleverage and reduce their loans-to-reserve capital ratios, they also need to be lending money to more small businesses in order to facilitate growth generation in the Eurozone.

Eurozone must be wary of the Domino Effect

Another risk is that the Eurozone is clefted by a two-speed recovery. Already Northern European countries such as Germany are showing a faster recovery than the Southern Europeans, such as Italy and Spain, that still find themselves mired in recession. The theory behind creating the Eurozone and the single currency, was that the impossibility of devaluation by member countries of the currency would enable it to be a harmonising force across Europe. However, there is de facto devaluation occurring within different countries evidenced in the contrasting unit labour costs, a manifestation of relative productivity. Germany’s labour costs have increased by 13% cumulatively since the euro launched in 2000, a bare change, whilst unit labour costs in Greece, Spain, Italy, and Portugal have risen by 20 to 30% since the euro’s inception. It is not only different countries that may be recovering at different speeds; it is also different sectors within the economy. Generally in Europe services are recovering faster than the manufacturing sector.

Outside of the Eurozone, fears of a tightening in US monetary policy due to the Federal Reserve stopping their asset purchase stimulus program could lead to higher bond yields in Europe. Higher bond yields would raise borrowing costs, with its biggest damage being potentially fuelling fears of Eurozone stagnation or break-up.

Despite all the negative data, optimism twists slight details as signs of economic recovery when more signs are necessary. Investors picked up on Goldman Sachs Asset Management’s increase of its exposure to European equities by doubling its position as they bet on the end to recession in Europe. Yet the bank’s trading data reveals that they do make big bets and sometimes take big losses. Optimism has also been captured by Markit’s composite purchasing managers’ index for Europe (considered an indicator of GDP data) shuffling to 50.7 in July, just slightly above the 50 mark indicating growth and a pick up in business activity. It is hardly a seismic shift worthy of pronouncing that recovery is in sight. The German PMI increased to 52.8 in July from 50.4 the month before on the back of gains in both the services and manufacturing sectors, yet Germany is also the stand-out performer in Europe. The stark contrast can be found with Greece, whose economy shrunk by 4.6% on an annual basis in Q2 2013, down from 5.6% in Q1 2013, which was swiftly proclaimed a gradual deceleration of the country’s longest-recorded recession of six years. We have been on the data merry-go-round several times before where data incites optimism which is revealed to be ill-founded the next month.

To solve the crisis requires consolidation of the many voices. This means more banking union, fiscal union and political union. The latter two however are likely to prove elusive.

Austerity is hardly the most effective antidote for Europe’s economic crisis. Yes, it could work if the demand squeeze imposed on the troubled peripheral countries engenders a fall in prices and costs relative to their neighbouring countries, which could then lead to greater competitiveness and a recovery in living standards and unemployment rates. Yet, this would take many years or even over a decade to occur. Unlocking spending is a better antidote for Europe, yet one that is difficult to institute with the bickering among the various parties due to a lack of fiscal and political union in Europe.

Spend, Spend, Spend!

Another option is for better-resourced European countries such as Germany to adopt inflationary policies or subsidizing policies that can facilitate the Southern European countries’ recovery. This is unrealistic unless the current geopolitical dynamics are transformed by closer fiscal and political union. At least banking union is being realized, which will help identify which banks need to be recapitalized and will enable banks to provide credit to SMEs again.

The European Central Bank may also have to cut interest rates and initiate another round of monetary easing in order to boost the European economy hampered by the ill-thought austerity policy’s spending cuts. Unlocking uniform spending across the Eurozone would boost growth and aid a recovery. Yet, it is more complicated than just tinkering with interest rates.

Firstly, let’s look at the drivers of spending. There are some overall drivers that influence spending such as:

·         Gross national income;

·         Minimum wage per month;

·         Inflation;

·         Birth rate;

·         Unemployment rate (male one in particular);

·         Manufacturing employment;

·         Finance and business services employment;

·         Foreign students in higher education;

·         Marriage rate; and

·         Divorce rate.

There are also drivers that influence personal care spending, where personal care is viewed as a necessity:

·         Median age;

·         Fertility rates;

·         Population completing high school;

·         Number of people per household;

·         Savings ratio;

·         Annual newspaper circulation;

·         Smoking rates;

·         Internet subscribers;

·         Students in higher education; and

·         Length of maternity leave.

The European government should target each of these measures to increase them, which like Abenomics’ Three Arrows philosophy in Japan, should work when they are all targeted in unison.