Assessing the European Elections
May 22, 2012
In the two years since the onset of the European sovereign debt crisis, policymakers have struggled with the issue of fiscal integration and the tradeoff between growth and austerity. Although many observers hoped that some clarity would emerge from the recent elections in Greece, France and Germany, political paralysis continues throughout Europe. In this edition of Strategic Spotlight, we discuss the fiscal and growth outlooks for key eurozone countries and the region overall.
EUROPE’S ECONOMIC OUTLOOK HAS WEAKENED
|European Commission Real GDP Forecasts|
|Spring 2012 Forecast||Change from Fall 2011|
|Source: European Commission. Spring 2012 forecasts released May 11, 2012.|
Countries in the Spotlight
Greece: Following several private debt exchanges and a downgrade by Standard & Poor’s to selective default (currently rated CCC), the poster child for the sovereign debt crisis continues to make waves and put investors on edge. Most recently, Greece’s political elections failed to yield a coalition government, which set the stage for another round of elections on June 17. Given the political uncertainty in Greece, we think it is less likely that the country will comply with its anti-growth International Monetary Fund (IMF) austerity program, which includes a variety of tax increases and a decrease in the minimum wage. While European Union (EU) finance ministers have dismissed a Greek exit from the EU as nonsense, the country will be at odds with Germany should they decide against implementing the program, which was agreed to in exchange for financial aid. Under this scenario, the possibility of a Greek exit remains on the table.
France: The win by Francois Hollande over incumbent Nicolas Sarkozy in France’s presidential election was widely anticipated but could potentially alter Europe’s political direction. President Hollande has criticized austerity in the past and we believe he will advocate a growth compact to go along with the fiscal pact the EU is working to ratify. Should France develop a disdain for outright austerity, this may impact how more indebted countries like Greece, Portugal and Spain are evaluated with respect to their structural reforms by both investors and the monetary troika (IMF, European Central Bank and EU).
Germany: As with most macro issues in the eurozone, Germany will largely dictate the course of the sovereign debt crisis. Ideally, Germany would like to reconstruct a stronger eurozone that consists of more fiscally conservative members. Given the developments in Greece and France, this may be difficult to achieve in the near term; indeed, German Chancellor Angela Merkel may need to tolerate fiscal imbalances for the time being. Longer term, Germany is likely to remain acutely focused on controlling inflation, even if it comes at the expense of growth in the broader region or prompts weaker countries to exit the euro bloc.
ECB’s Central Role
As opposition to austerity measures spreads across Europe at a time when the growth prospects for the region are weak, the ECB will have to play an important role for the European economy in the months to come. The central bank has been hesitant to do more after cutting rates twice late last year to the all-time low of 1.0% and implementing two non-standard LTRO (long-term refinancing operation) programs; still, ECB President Mario Draghi has stepped up as needed, playing the role of lender-of-last-resort to the banking system. Draghi will need to continue to do so as Europe works through the next stage in its sovereign debt crisis. We would not be surprised to see further rate cuts and another LTRO-type program to combat economic andfinancial market strains.
What to Expect
We strongly believe that European policymakers would like to keep the 17-member eurozone intact as the fallout and contagion from a euro breakup would severely impact growth in the region. That being said, investors and policymakers alike know full well that one mutual monetary policy and 17 separate fiscal policies is a recipe for failure. The most important question in the near term following the recent elections is whether Europe’s new political direction will weaken the resolve to reach fiscal solidarity within the 17-member monetary union. Achieving fiscal union, while at the same time engendering an environment of growth (and thereby reducing deficits), is a delicate balancing act that the ECB and heads of state continue to engage in. To keep the eurozone intact, we think greater emphasis needs to be placed on near-term growth; we believe French President Hollande and German Chancellor Merkel are slowly coming to terms with this realization, which should benefit the broader region in 2013 and beyond.
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