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Immediate risk of break-up has passed, but remains a threat

THE UPCOMING second set of Greek elections and the French parliamentary elections that followed François Hollande’s accession as French president will have important consequences. The socialist victory in France will provide Hollande with political authority as he tries to persuade Germany’s Angela Merkel to relax fiscal austerity and increase spending to support growth. In Greece, the narrow win of the pro-bailout parties will ease fears of an immediate exit. But the new Greek government will face internal opposition, and will want concessions that others will oppose. Disagreements between France and Germany have been kept under control, but reaching a compromise will be hard. Tensions could worsen if the eurozone economy weakens further. A euro break-up is not imminent, but remains a threat.

Economic risks have worsened. Earlier fears of a disorderly Greek exit have triggered large outflows of bank deposits. Recently, the markets have also become concerned that the global slowdown will be even sharper than initially thought, and will also affect China and India. As confidence wanes, preventing a major banking crisis has become the main priority for eurozone governments and the European Central Bank (ECB). Unless banking threats are contained rapidly, the loss to confidence could be irreparable.

The haemorrhaging of Greek deposits, though disturbing, was not critical. But it was vital to stop contagion, most notably to Spain, the fourth-largest eurozone economy. After the Spanish government was forced to spend €19bn (£15bn) on effectively nationalising Bankia, the country’s ailing third-largest bank, speculative pressures continued.

In response, European finance ministers agreed to a €100bn support package for Spain’s weak banks, which are still coping with losses from the recent property crash and may be unable to withstand a new recession. By restricting the rescue plan to Spain’s banking system, the need of a formal sovereign bailout was avoided – it would have been expensive, as well as politically unacceptable for the Spanish. But the markets’ reaction was sceptical, and yields on 10-year Spanish sovereign debt rose above 7%, a level often regarded as prohibitively high, which forced other vulnerable eurozone members to apply for a full bailout entailing strict conditionality.

Policy differences

Eurozone GDP was flat in the first quarter of 2012, after falling in the previous quarter, while unemployment in April was 11%, the highest since the euro’s 1999 launch. Over the past year, the eurozone economy as a whole has been stagnant. There are worrying signs that recessionary pressures are worsening, and GDP is highly likely to record negative growth in 2012.

The contrast between positive growth in Germany and declines in Spain, Italy, Greece and Portugal will intensify policy differences. While Germany argues that growth depends on structural reforms and improved competitiveness, the weaker members, now backed by France, want to see more active intervention to stimulate activity. Since these differences will not be resolved quickly, it is vital to reinforce firewalls defending banking systems.

The operation to support the Spanish banks was successful, but an ad-hoc measure. It is necessary to create a general eurozone banking union that would involve governments as well as the ECB. Policy disagreements will persist, but the banks must be ring-fenced to minimise threats of a future crisis. The ECB will be particularly important in easing tensions. As well as supplying ample liquidity to commercial banks, it is likely to cut its key rate to 0.75% in the next two to three months. Official ECB rates will not be raised until the third quarter of 2013 at the earliest.

In contrast to the recession facing the eurozone, the US economy is growing, but the pace is mediocre and slowing. GDP grew at an annualised rate of only 1.9% in the first three months of 2012, less than first estimated. The labour market is weakening. Job creation in May was a disappointing 69,000, much less than expected, and well below the first-quarter average. The jobless rate rose to 8.2% in May, much lower than in the eurozone but unacceptably high for the US. House prices are slowly stabilising, but are still 2.5%-3% lower than a year ago.

US consumers remain under pressure. Since 2007, the median US household has experienced a fall in real incomes and a drop in wealth, mainly due to big declines in house prices. The Federal Reserve funds rate will remain at 0%-0.25% at least until the final months of 2013, and other stimulus is likely. More quantitative easing (QE) is not imminent. But a dose of Operation Twist is expected: the Fed sells short-term bonds and uses the proceeds to buy, and push down the yields on, longer-term bonds. This will reduce key mortgage interest rates, thus helping the housing market.

UK recession

Meanwhile, the UK is in technical recession, as revised figures show a further 0.3% GDP fall in the first quarter of 2012. Many still question the official figures, but it is clear that the UK economy has been stagnant over the past 12-18 months.

The government must implement a firm deficit-cutting plan, but it has to be supplemented by more effective growth-enhancing policies. Conventional QE has not been very effective in boosting the real economy, but monetary policy must remain expansionary. As well as keeping the Bank Rate at 0.5% until the final months of 2013, the Monetary Policy Committee may still increase QE above £325bn if the eurozone situation risks causing problems for the UK financial system. The welcome fall in UK inflation to 2.8% in May 2012 will reinforce calls for an increase in QE. ?

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