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Deceptive calm masks depth of problems in eurozone

ESCALATING TENSIONS, which threatened the euro’s survival earlier in the year, subsided during the summer months. Traders and analysts relaxed for a few weeks, and shifted their attention to the London Olympics. But the underlying problems remain unresolved, and new storms will probably erupt before long. A disorderly eurozone break-up remains the biggest single threat to global economic stability. There are also worrying signs of a slowdown in China, and other Asian economies.

The European Central Bank (ECB) continues to perform a critical role in stabilising vulnerable banks. Progress towards banking union is still too slow, and the ECB’s ability to support sovereign governments directly is limited. But having secured broad consensus for an enhanced role – in spite of German reservations – the ECB is now better placed to respond effectively to new crises. However, fundamental policy differences persist and may intensify. Hard-line countries (e.g. Germany, Finland and the Netherlands) are determined to avoid the “moral hazard” of extending “blank cheques” to those that are repeatedly over-spending and borrowing.

Inadequate firepower

Although François Hollande’s election as French president has strengthened the hand of those wishing to relax the fiscal austerity (e.g. Italy, Spain, Greece and Portugal), Germany is prepared to make minor concessions only, and its position is still pivotal. A major reassessment of the German position is unlikely to occur until threats of a major banking crisis, or a chaotic disintegration of the euro, escalate again. Internal political and legal pressures within Germany have reinforced opposition to helping weak members. But the euro has provided German business with huge benefits over the years. In spite of populist clamour, a return to the old Deutsche Mark is unrealistic. Germany will reluctantly be prepared to pay a high price to save the euro, if this proves absolutely necessary. But even Germany’s huge firepower may be inadequate.

Eurozone economic conditions are worsening, with unemployment rising in June to a new record high of nearly 18 million people. The jobless total increased over 14 consecutive months, by a cumulative total of more than 2.2 million. The unemployment rate in June was at a record high of 11.2%. If the recession worsens, that rate could rise above 12% in 2013, and this may prove politically explosive. Huge gaps between core and periphery are exacerbating tensions. Germany, the Netherlands and Austria are experiencing low jobless rates of about 4.5-5.5%, while the rates are about 20-25% in Spain and Greece. Exceptionally high rates of youth unemployment, which are now more than 52% in both Greece and Spain, will intensify opposition to austerity, and will make it more difficult to reach policy consensus.

With eurozone GDP likely to fall by some 0.5% in 2012, followed by anaemic positive growth of less than 1% in 2013, it is clear that the ECB will persevere with expansionary monetary policies. The key policy rate was cut recently to 0.75% (with the deposit rate at zero), and we expect a further cut to 0.5%. In spite of the ECB’s concerns over inflation, rate increases will not be considered until the fourth quarter of 2013 at the earliest, and ample liquidity will continue to be made available to commercial banks. This will be helpful, but the euro’s long-term survival cannot be guaranteed without a full banking union and greater fiscal integration.

Disappointing improvements

US economic performance remains disappointing, but is still much better than in the eurozone. GDP grew at an annualised rate of only 1.5% in the second quarter of 2012, below the 2% growth in the first quarter. But US house prices have risen in recent months; year-on-year comparisons are now showing declines of only some 1%, and will soon become positive. US job creation is also improving, with 163,000 new jobs in July, well above expectations and more than double the June figure. The unemployment rate also increased in July, from 8.2 to 8.3%, but this is because more people are joining the workforce and are looking for a job. In the face of these mixed messages, the Federal Reserve has not yet decided to launch a new dose of quantitative easing (QE). But an expansionary move is possible if the economy stalls. The Fed funds rate will stay at 0-0.25% until 2014.

Chinese year-on-year GDP growth fell to 7.6% in the second quarter of 2012, the slowest expansion for three years. Though still very high when compared with the US and Europe, the new figure highlights a steady and pronounced downward trend in China’s growth, from 11.9% in the first quarter of 2010. China’s annual consumer inflation dropped to 1.8% in July, making it necessary to ease policy further. The People’s Bank of China – the country’s central bank – has already cut its key interest rate in two stages since early June, from 6.56 to 6%, and a further cut to 5.75% can be expected. Bank reserve requirements will also be cut.

The UK technical recession has worsened, with a preliminary GDP fall of 0.7% in the second quarter of 2012, after smaller falls in the previous two quarters. The official figures exaggerate the decline, but the UK economy is clearly stagnant and the fiscal plan must be supplemented with growth-supporting policies. Conventional QE, which was raised recently to £375bn, has had marginal effects only in boosting the real economy. It would be preferable if, as well as keeping Bank Rate at 0.5% at least until the final months of 2013, the Monetary Policy Committee concentrates on additional direct measures aimed at increasing lending to the private sector.

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