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Eurozone growth can’t move beyond first gear

Publication Date : 23-08-2014


Not unlike most forecasters (including World Bank, Asian Development Bank, Organisation for Economic Cooperation and Development and US Fed), the International Monetary Fund’s (IMF) mid-year update tells the same story of consistent over-estimations since 2009, in a long line of serial misjudgements.

They blame unanticipated factors for the inaccuracies. Never their outdated models.

For now, global growth is expected to rebound from the second quarter of 2014 (Q2’14) to register a marked-down rise of 3.4 per cent for 2014 as a whole; projection for 2015 remains at 4 per cent.

Similarly, growth in the eurozone is “expected to strengthen to 1.1 per cent  in 2014 and 1.5 per cent  in 2015.” Still too optimistic, I feel, given the prospective conditions. Today, we know better.

Definite weakening

As I write, evidence is building that the conflict in Ukraine and the United States/European Union (EU) sanctions and Russia’s counter-sanctions are undermining eurozone/EU recovery that president Draghi of the European Central Bank (ECB) has already judged to be fragile at best. Chronically deficient demand is definitely holding back EU growth.

A clear sign came on Aug 6 when the Italian economy fell back into recession, with GDP down by 0.2 per cent in Q2’14 (minus 0.1 per cent  in Q1’14).

Seriously, Italy never emerged from recession in practice – in the past 12 quarters, it had only one real growth quarter.

The economy is today more than 9 per cent  below its pre-crisis peak and when adjusted for inflation, its GDP is of the same size as it was in 2000. Italian youth unemployment now exceeds 40 per cent and its sovereign debt, 133 per cent  of end 2013 GDP.

Last week, EuroStat signalled that eurozone GDP was flat in Q2’14 (+0.8 per cent  in Q1’14) and remains at 2.4 per cent  below its pre-crisis peak, leaving it vulnerable to outside shocks.

In Germany – EU’s strongest economy – GDP shrank 0.2 per cent from Q1’14; business confidence is dropping for the third straight month; the DAX share index is down 9.3 per cent  from its July 3 record high; and inflation stands at a low 0.8 per cent.

Moreover, France’s economy stagnated for a second straight quarter, with manufacturing activity contracting at the fastest pace so far this year.

Eurozone’s three largest economies, accounting for tow thirds of the region’s 9.6 trillion euro GDP, are among the worst-performing.

Indeed, unemployment was held at 11.5 per cent in June, still close to the record high. So, growth in Europe continues to struggle to gain momentum.

Also, Greece, Ireland, Portugal and Spain will have a difficult enough time keeping their heads above water; add deflation to the outlook, and Europe is in for a real tough time ahead.

Indeed, it still remains unclear to me whether the eurozone really did emerge from recession, despite experiencing four consecutive quarters of growth, albeit these have been weak and uneven and accompanied by only a slight improvement in jobs.

The Euro Area Business Cycle Dating Committee of the Centre for Economic Policy Research has intimated that the eurozone may be just in a “recession pause,” and warned that the contraction which first began in late 2011 may well resume.

This Committee officially dates the “peaks and troughs” of economic activity in the same way as the US National Bureau of Economic Research’s Business Cycle Dating Committee, placing more weight on job outcomes.

It is noteworthy that the Committee’s judgement has since prompted ECB to introduce a package of measures on June 5, aimed at boosting growth and inflation.

It would now appear that these stimuli may be too timid since the situation has worsened. Most economists think that the ECB’s case for QEII (second round of quantitative easing) has now become more compelling.

“Lowflation” to deflation

Latest data suggests inflationary pressures in the eurozone remain subdued. Inflation is falling in the year to July (0.4 per cent), the lowest in more than four years.

It had fallen to 0.5 per cent  in May and June from 0.7 per cent  in April, taking it further below the ECB’s target of close to 2 per cent .

As I understand it from my euro-friends, ECB’s most recent projections have inflation undershooting this rate even at the end of 2016!

Further, in early August 2014, Germany’s 10 year break-even rate (a measure of inflationary expectations) fell to 1.27 per cent, the lowest since 2012.

To be fair, core-inflation (i.e. excluding food and energy prices) is no longer falling. But, at 0.8 per cent in July, even this measure’s still far too low.

Besides, the conflict in Ukraine and the Gaza/Israel and Syria-Iraq wars are undermining recovery. Their impact is causing concerns among large European firms (including Anheuser-Busch Inbev NV and Siemens AG). The turmoil is beginning to hurt business and making Draghi’s life increasingly more uncomfortable.

The June 5 stimulative measures (bringing lending rate down to a new low of just 0.15 per cent, moving to negative deposits rates at ECB and, extending cheap long-term re-financing to boost targeted bank lending) now appears to be “too little, too late.”

So far, they don’t really amount to much. IMF’s Lagarde speaks of deflation as an ogre which must be fought decisively.

At this time, with recovery so very fragile and the macroeconomic situation so fluid, the major worry has been the possibility of a plunge to deflation, or falling prices – a serious twist which acts to deter consumers and businesses from spending, with the expectation that they can wait for prices to fall further and buy more cheaply later.

This would bring down demand and make businesses postpone investment outlays, thereby hurting jobs and setting in motion a vicious cycle that can choke-off growth.

History has shown that it is notoriously difficult to reverse deflation once the spiral takes hold (Japan is a living example).

“Lowflation” is already hurting eurozone debtors since incomes are rising more slowly (if any) than expected when they first borrowed. As this mutates into deflation, the real burden of debtors rises when prices fall.

Overall effects are particularly pernicious in the eurozone where private and public debt levels in most nations are perilously high.

QE as last resort

The case for quantitative easing (QE) now in eurozone is especially compelling. QE – creating money by the central bank to buy financial assets to spread the monies around – is already orthodox practice.

It’s being used in the United States, Japan and the United Kingdom (until 2012). Already, Cyprus, Ireland, Portugal, Spain and Greece have recorded wage declines in Q1’14.

Yet, ECB will only use it as a last resort measure even though broad money supply rose this year by only about 1 per cent .

Why? Because doubts surround the efficacy of QE:

(i) banks dominate in providing credit in eurozone, not bond markets which are not big and deep enough, and where asset-backed securities badly need reform – whereas mature and deep US bond markets best meet US needs; and

(ii) small businesses require direct access to credit which QE can’t meet in order to galvanise recovery in the peripheral. Besides, Germany worries QE makes less credit-worthy members forsake badly needed reforms.

Of course, these risks are real. Still, IMF repeatedly pushes ECB to be ready for QE to “boost confidence, improve corporate and household balance sheets, and stimulate bank lending.”

But, eurozone did “cross the Rubicon” in September 2012 which then saved the euro from the fury of market speculation. ECB has since left rates on hold with no new initiatives in early August 2014. It certainly needs to do much more.

What then, are we to do

Europe is haunted by what economist Mohamed El-Erian calls “the One-Percent Troika”: enrichment of the 1 per cent of its wealthiest; years of anaemic 1 per cent growth; and inflation hovering around 1 per cent.

The longer they persist, the recovery gets more fragile and more uneven in the face of structurally high unemployment, destabilising high youth joblessness and worsening high debt burden.

This Troika signals a call for urgent action to get on with a pro-growth agenda.

The mild stability eurozone now enjoys is illusionary. Sure, political fears in Berlin are real.

But I think the “bigger fear” lies in eurozone continuing to limp along, mired in a deep rut of mass unemployment, weak consumer prices and disincentives to invest – all eroding its growth potential in the face of unsustainable high debt.

For once, the IMF’s call is right-on – it’s time to bring on QE before deflation engulfs Europe.

But easy money alone is not enough. The new numbers are a wake-up call to the “Big 3” to lead and go for real reforms to push private investment and hiring. ECB has to do whatever it takes, as Draghi had promised. It just hasn’t done enough to secure a healthy recovery.


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