THE EUROZONE crisis rumbles on, and it is still unclear whether we are witnessing a tragedy or farce. But the consequences of a disorderly breakdown could be devastating, both for Europe and the wider world.
Repeated efforts to restore stability have been inconclusive. Europe’s leaders agreed a package that purported to deal with all the key issues – namely, reducing Greece’s debt, bank recapitalisation and increasing the firepower of the eurozone bailout mechanism.
But the enthusiastic market reaction to the Greek deal proved to be short-lived. Many contentious details have yet to be ironed out, and tensions between the German-led core and the periphery remain unresolved and may in fact escalate as Greece and its eurozone partners have become involved in dangerous brinkmanship.
Greece’s bailout, which imposed painful austerity measures, unleashed a political crisis. In response to overwhelming pressure from Germany and France, prime minister George Papandreou had to abandon his idea of holding a referendum on the rescue terms and subsequently resigned in order to give way to a national unity government.
But the Greek crisis is far from over. In spite of the bailout, it seems likely a more formal default will eventually be needed. For the first time, the possibility that Greece would leave the euro is now being debated openly. Such an event would have far-reaching consequences and could endanger the euro’s survival. But, partly as a result of the terms of the Greek deal, the threats have become more imminent because of new problems engulfing Italy.
The European Central Bank (ECB) and many other eurozone members have reluctantly agreed to German demands that private sector lenders should be forced to accept significant losses of their Greek exposure. But to avoid legal problems associated with a formal Greek default, Europe’s leaders insisted on the fiction that these losses – or “haircuts” – should be regarded as voluntary. Not surprisingly, this device did not fool the markets.
Holders of other peripheral debt sought to protect themselves by insisting on a wider yield gap versus Germany. The impact on Italy was particularly severe, as the yield on its 10-year bonds surged above 7%, a new euro-era high and a punishing cost for a heavily indebted nation.
Italy, the eurozone’s third-largest economy, is facing political turmoil. Prime minister Silvio Berlusconi has resigned, with his replacement Mario Monti promising to act “with urgency”. But if Italy’s situation worsens, the euro’s moment of truth may be nearer than many think.
The eurozone economy is sinking. Business surveys point to falling activity, both in manufacturing and services. Many analysts expect negative growth in the current quarter and in Q1 2012. Our new GDP forecasts show a drastic downgrading of eurozone 2012 growth to only 0.5%, lower than in the US, Japan and the UK.
The dire economic situation has made it necessary for the new ECB president, Mario Draghi, to take the unusual step of inaugurating his term of office by cutting interest rates. Draghi would have preferred to use the first meeting under his leadership to demonstrate his credentials as a firm anti-inflation fighter and defender of monetary stability. Instead, he announced a cut in the key ECB rate, from 1.5% to 1.25%, thus reversing one of the two increases made by the ECB earlier in the year.
The rate cut was effectively forced on the ECB, after Draghi warned that the economy is “heading towards a mild recession by year-end”. But further steps will be needed to support the economy. We expect a further ECB rate cut to 1% in the next two or three months. With inflation at 3%, well above the target, the ECB is reluctant to ease policy, but increases in the policy rate are very unlikely until the end of 2012 at the earliest.
The US economy continues to perform better than that of the eurozone. Though the American public is very unhappy with president Barack Obama’s record, and the recovery is weak by historical standards, there is no risk of recession and many key US indicators are slowly improving.
The 80,000 October increase in US payrolls was slightly smaller than expected, but job rises in the prior two months were revised up by 102,000, and unemployment fell in October to a six-month low of 9%.
Overall the weak US labour market is making progress. The US housing market is still weak. But GDP has grown an annual rate of 2.5% in the third quarter; this is less than in previous recoveries, but almost double the 1.3% growth seen in the second quarter. In spite of the improvement, the Federal Reserve confirmed its expectation that it will keep interest rates on hold “at least through mid-2013” and that it will continue with the $400bn “Operation Twist”, which aims to drive down long-term interest rates.
In the UK, GDP growth in Q3 2011 was 0.5%, better than the 0.3% expected by the markets, and a considerable improvement on the minimal 0.1% rise recorded in Q2. But unemployment is rising, and there are serious concerns that the eurozone crisis, coupled with the impact of the fiscal austerity plan, will have a negative impact on the economy.
To counter these risks, the key UK policy rate is likely to stay at 0.5% – at least until the end of 2012. In spite of high inflation, the markets expect a further increase in the quantitative easing programme within the next few months. ?
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