Europe’s economy is likely to shrink this year and to see little or no growth in 2013. Please note: That’s if all goes well. The International Monetary Fund’s dismal new forecasts assume -- or let’s say hope -- that Europe’s plan for restoring stability will soon take effect. Don’t take this for granted.
Output in the euro area will shrink 0.4 percent this year and rise by just 0.2 percent in 2013, according to the new projections. The outlook has worsened since the IMF released its previous forecasts just three months ago. And the risk is that it will worsen further.
With lower growth, the region’s troubled economies face calls for yet more tightening. Spain in particular has announced new spending cuts and tax increases, anticipating the conditions that the European bailout fund will attach to a rescue package. These conditions must be in place before the European Central Bank can start its promised purchases of Spanish government debt.
If the cuts happen, they will further hamper economic growth. Outright political collapse is a risk in Greece. It’s none too remote in Spain, either, where separatist pressures are on the rise.
Enough is enough. Spain has already cut its “structural” or cyclically adjusted budget deficit from almost 10 percent of gross domestic product in 2009 to an expected 3 percent in 2013. Three years ago, Greece had a structural deficit of 18.6 percent of GDP; the IMF says this will fall to 4.5 percent in 2012 and 1.1 percent in 2013. Italy’s structural deficit was an already modest 3 percent in 2009; next year, there’ll be a surplus. All this against the background of shrinking output.
It’s clear Europe has overdone austerity. The IMF says as much in its new World Economic Outlook, noting that fiscal tightening has depressed demand (and hence output) more than previously expected. This has happened partly because, with interest rates close to zero, conventional monetary policy has been unable to take up the slack.
Better late than never, euro-area governments should recognize this. They shouldn’t abandon the commitment to stabilize and then reduce public debt over the medium term. The question is how to make that promise credible.
At a minimum, they should agree that when fiscal slippage is caused by slower-than-expected growth and not backsliding on policy, they will relax the fiscal timetable rather than adopt a new round of unreachable targets.
There is a danger that financial markets might veto such forbearance by forcing up interest rates. It’s unlikely, though, because investors understand that Europe has locked itself into a vicious circle of slow growth and excess austerity. Patience on austerity makes the commitment to medium-term consolidation more feasible -- so long as individual governments aren’t seen as reneging on their longer-term plans.
The euro-area governments should also remove any doubt about their commitment to a collective plan for financial recovery. The EU took a stride in the right direction last month by announcing its ambition to create a banking union. Done right, this would lower interest rates for the countries facing greatest stress, helping to restore fiscal as well as financial stability. That’s the key. The link between fiscal pressure and financial panic is the core of Europe’s economic problem, and it must be broken.
Yet Germany and others have now cast doubt on the banking plan. They argue, for instance, that systemwide deposit guarantees would mean disguised fiscal transfers.
Investors also thought that the European Stability Mechanism, the permanent bailout fund, would inject new capital directly into troubled banks (notably in Spain), rather than through national governments. Such an approach would avoid adding to the debts of distressed governments. Germany says no, that’s not what we agreed to.
Euro-area leaders should clarify and accelerate their plans for banking support -- in effect, tell investors that the first optimistic assessments of the plans for banking union were right, after all. Where new public debt reduction will be necessary (as in Greece, beyond a doubt) it should be done sooner rather than later. And the European Central Bank should take up its promised new role as lender of last resort to euro-area governments immediately -- not later, not maybe, and not after a long list of ever-changing conditions has been met.
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