THE GREEK ELECTIONS, which show large gains for opponents of austerity and threaten a period of political instability, could trigger an early crisis. Default and/or exiting the euro are unlikely, but cannot be ruled out.
In the longer term, Franc?ois Hollande’s election as French president is more important, though the full implications are still unclear. Chancellor Angela Merkel of Germany has made clear her preference for Nicolas Sarkozy. Hollande’s assertion that he would not ratify the fiscal discipline treaty without a renegotiation that adds growth measures is causing alarm in Berlin. The Germans see the treaty as vital for the euro’s survival, and they would feel betrayed if France, their most powerful ally, abandons its support.
Initially, there will be efforts to blur deep differences between Germany and France, while the main focus will be on Greece. But a real compromise will be difficult to secure. Germany wants to achieve growth through improved competitiveness and structural changes, but opposes stimulus through higher debt and deficits. New EU- led investment initiatives may offer a temporary palliative.
However, Germany is only likely to tolerate measures that do not breach the basic aim of cutting budget deficits. Reaching agreement will necessitate difficult choices. President Hollande may tone down his apparent enthusiasm for Keynesian policies due to concerns over the adverse reaction of the financial markets. But if France and Germany fail to avoid a build-up of frictions, threats to the euro’s survival will inevitably escalate. Thee difficult economic background, as eurozone output falls and unemployment rises, can only aggravate tensions.
Thee eurozone jobless rate rose in March to a new peak of 10.9% of the workforce, the highest since the euro was established in 1999. Countries hit by the financial crisis have recorded the highest unemployment rates: Spain at 24.1% and Greece at 21.7%. Very high youth unemployment – more than 20% in the eurozone as a whole, and more than 50% in Spain – is a politically explosive issue that will reinforce demandsfor a policy shift towards growth, and will strengthen the negotiating position for president Hollande.
Even in the unlikely event that Germany were to relax its insistence on firm discipline, the financial markets are unlikely to allow any major policy easing. Talk about a Europe-wide backlash against austerity may prove temporary, once confronted with the markets’ insistence on budget discipline.
Given these uncertainties, the European Central Bank (ECB) kept its key policy rate at 1% in early May, disappointing hopes of a reduction. But due to the risks of a Greek crisis, I still expect an early cut in the key ECB rate to 0.75%, coupled with an injection of additional liquidity. Such action by the ECB will ease recessionary pressures in the periphery and will limit the risks of a new sovereign/banking crisis erupting. By easing monetary policy further, the ECB can facilitate a compromise between Germany and France, as it will be encouraging structural reforms without taking undue risks with fiscal restraint. However, I remain convinced that ECB official rates will not be raised until mid- 2013 at the earliest.
Meanwhile, US economic growth remains stronger than in the eurozone. But there are worrying signs that the US recovery is flagging, with disappointing growth and job figures. GDP rose at an annualised rate of 2.2% in the first quarter of 2012, which stands slightly lower than the expected increase of 2.5%, and well below the 3% growth recorded in the fourth quarter of 2011.
US house prices are still showing year- on-year falls of 3.5%, and housing starts dropped to a five-month low in March. Thee US economy created only 115,000 new jobs in April, well below analysts’ expectations of an increase slightly above 160,000. Thee jobless rate fell from 8.2% to 8.1%, but that was mainly because many discouraged workers have left the labour force and are not looking for work at present. Job creation in the US is clearly inadequate for a sustainable recovery.
But the economy is not yet weak enough to persuade the Federal Reserve to inject a further instalment of quantitative easing (QE). The Fed funds rate is set to remain at its current exceptionally low 0-0.25% level for at least another year. As the Fed keeps policy on hold, while the ECB eases further, it is reasonable to expect a rise in the dollar versus the euro in the next few months.
In the UK, preliminary official figures show a 0.2% GDP fall in the first quarter of 2012. Coming after the 0.3% decline in the fourth quarter of 2011, this means that the UK is now in technical recession. However, most analysts and business organisations have expressed doubts over the accuracy of the first-quarter estimates, since they are mainly due to declines in construction and manufacturing, which many regard as highly erratic.
Thee Bank of England’s Monetary Policy Committee (MPC) also questioned the official GDP figures. At the April meeting of the MPC, the number of those voting for an increase in QE had come down from two to one, and most analysts now believe that UK asset purchasing will not be raised above £325bn. Even if fears of recession are exaggerated, though, the UK economy is stagnant. The big losses suffered by the coalition parties at the local elections will reinforce pressures for more effective growth policies. But the deficit-cutting plan is unlikely to be abandoned.
David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist
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