FROM THE ECONOMIST INTELLIGENCE UNIT
Europe is in the midst of a profound economic and financial crisis, which, among other things, raises real questions over the future viability of the euro. Politics will be more confrontational in 2011, both within individual countries and between them. The political will to implement austerity measures will be tested in distressed euro zone states, as will the readiness of creditor countries to sustain financial support. It cannot be ruled out that Europe will witness its first sovereign defaults since 1948, which would put huge strains on banks’ balance sheets, potentially triggering further bank recapitalisations in core euro states. The EU economy has revived somewhat following an unprecedented contraction in 2008-09, but the recovery will remain faltering and uneven, with some countries recovering pre-crisis output levels quickly and others suffering long and painful adjustments.
* Euro crisis. The sovereign debt crisis will continue to cast a shadow over the euro zone, and doubts about the single currency’s long-term survival will not easily be assuaged. Policymakers are slowly coming to terms with the fact that the survival of the euro area cannot simply be taken for granted and will depend on careful management of current stresses in the bond markets and weak banking systems, as well as reforms to fiscal governance and more determined efforts to tackle structural problems. Our core forecast is that the euro zone will avoid collapse in 2011, but there are likely to be more than a few uncomfortable moments. We expect that Portugal will be forced to access the EU/IMF financial stability fund, while Spain will need to roll over about 21% of its public debt in 2011, in addition to financing a budget deficit of over 7% of GDP. Financial-market jitters could resurface for many reasons, but a particular concern would be if investors became fundamentally convinced that the EU/IMF fund, nominally worth €750bn (US$990bn), was inadequate to bail out those countries needing assistance. Spain probably won’t need to request a bail-out, but the size of its economy means that any doubts on this front would present a particular risk to euro zone stability. The European Central Bank (ECB), meanwhile, by purchasing government bonds, has stepped into politically controversial territory and is likely to find it increasingly difficult to step back.
* Austerity. The need to reduce large budget deficits will remain an obvious challenge for many members of the euro zone, and also for the UK. In 2011 austerity will become more visible in European countries as cuts in public services and pay bite. Economic conditions will also be rendered more difficult by the fact that the drivers of the global recovery in 2010 will have largely faded. A key question will be whether the supposed “cure” for fiscal ills will do the “patients” more harm than good by undermining economic growth so much that fiscal ratios worsen—or, at least, fail to improve as much as policymakers had hoped. Moreover, if fiscal tightening starts to jeopardise the recovery, it may tempt governments to defer necessary austerity measures. The UK will prove a good test-case in this regard. The coalition government’s dramatic five-year fiscal consolidation programme comprises a mix of tax rises and the deepest sustained period of real-term public spending restraint since the 1940s. We remain of the view that policymakers are over estimating the ability of a structurally weak private sector to drive economic activity as austerity bites, which could see the government facing the dilemma of either choking off the recovery or risking a rapid shift in investor sentiment by backing away from its fiscal targets.
* Social unrest. Deep spending cuts and tax rises could have serious detrimental impacts on social and political stability. Sacrifices have been and will continue to be demanded of all those receiving salaries, pensions or other benefits from the state, while unemployment among public-sector workers is likely to increase. Greece in particular has been facing ongoing strikes against government austerity measures, by both public- and private-sector workers. We expect widespread industrial unrest to continue, but do not expect unrest to undermine the government’s efforts to rein in its budget deficit significantly. Political stability in Ireland will be significantly tested. So far, Irish citizens have accepted two years of austerity budgets with little protest. But the prospect of deeper cuts in the years ahead—as demanded by the EU/IMF as a condition of Ireland’s €85bn rescue—is likely to inspire social unrest. Dangers of social strife in other EU countries exist, but are lower than in the case of Greece and Ireland. Portugal has already undergone a long period of austerity and weak growth. Spain is only at the beginning of a period of public-sector tightening, but is over two years into a recession caused by a collapse in its property market (as well as the international financial turmoil) and has seen unemployment rise to over 20%, double that of most other countries, without so far experiencing anything worse than disciplined and peaceful protests. In France, recent trade union strikes to protest against an overhaul of the state-pension system served as a reminder of the potential for protests to cause significant economic disruption and trigger outbreaks of rioting. The government is likely to delay any further controversial reforms ahead of the 2012 elections. Trade unions in the UK are also expected to stage strikes as the scope of the government’s public-sector cuts become clearer. Comparatively tight legal restrictions on the ability to strike in the UK (in contrast to many other EU countries) will help the coalition to some extent, but we think that the scale of social unrest will prove to be considerably greater and more widespread than is currently assumed.
* Political relations. The most important bilateral relationship in the EU is between Germany and France, both because their reconciliation laid the foundation of EU integration, and because they are the two largest euro area economies. As the political dynamics of the ongoing sovereign debt crisis demonstrate, Germany’s role in Europe is now more central than it has ever been. We expect Germany to maintain its commitment to the euro, but its increasingly assertive promotion of its national interest and reluctance to discuss the issue of macroeconomic imbalances within the euro area could trigger wider tensions. Relations between Chancellor Merkel and President Sarkozy have long been difficult and as discussions over how to hold the euro area together continue, frequent shows of unity are likely to be undermined by fundamental disagreements on crucial matters. There is a risk that relations could deteriorate. In general, French attitudes to the EU have become more sceptical in recent years, as the increase in the EU’s membership has reduced France’s influence. Mr Sarkozy may be able to point to the reform of financial regulations as evidence that the EU is developing in line with France’s aims, but the sovereign debt crisis has also increased the likelihood of a clash with the EU over the poor state of the French public finances.
* State aid. Given how dependent many financial institutions are on national government and ECB assistance, the removal of the panoply of support measures (including liability guarantees, infusions of capital, government purchases of impaired assets and cheap central bank funding) might precipitate the failure of institutions and a further bout of financial panic. As a result, the phasing-out of support will be gradual. At the same time, efforts will continue to reconstruct internally those financial institutions that are being buttressed by government support. Having waved through all rescue packages at the height of the panic, the European Commission is now reasserting itself. It has already imposed large-scale downsizings on some banks, and more are being scrutinised. From the start of 2011, all financial institutions receiving state aid will be obliged to submit restructuring plans to the Commission (whereas previously this requirement was restricted to banks receiving support above 2% of their risk-weighed assets). The Commission’s active intervention is justified on the grounds that institutions that require state aid cannot be allowed an advantage over those that have survived unaided.
* Financial reform. The implementation of a revised regulatory architecture for financial institutions will be high on the agenda, at national, EU and international levels. At the level of the EU, in September 2010 member states and the Parliament approved a major reform of the EU’s financial supervisory framework that will enable the creation in January 2011 of a European Systemic Risk Board (ESRB), responsible for macroeconomic supervision, and three new bodies to oversee the supervision of banks, insurers and securities markets throughout the EU. European supervisory authorities (ESAs) will be charged with developing and helping to enforce a common rule book and reinforcing day-to-day supervision by national authorities. There is still considerable scope for any recommendations and decisions to be overturned by governments on the grounds of national budgetary competences. However, together with the new ESAs for the banking sector, the ESRB is likely to have considerable influence over future measures to counter the build-up of risk in the European financial system, such as capital boosts, counter-cyclical capital buffers or maximum loan/value ratios.
* EU budget. The common agricultural policy (CAP), an elaborate mechanism to maintain prices of agricultural goods, was central to setting up the EU’s forerunner more than half a century ago. Although it has been reformed to be less market-distorting and costly for European taxpayers, many members wish to see further reforms designed to diminish EU intervention, whereas others are adamantly opposed. Recent extreme volatility in food prices and concerns about security of supply have strengthened the latter grouping. The CAP currently accounts for just under half of the total EU budget. Negotiations on how the CAP will be structured and funded for the next budgetary period (2014-21) will be time-consuming and contentious. Although the EU budget accounts for a mere 1% of member states’ combined GDP, and is unlikely to rise above this level, the amount that each member contributes generates some of the bloc’s most divisive and protracted disagreements. The next negotiations, which are already under way, will be at least as difficult as any before owing to the historically large deficits that many member governments are facing. The UK is leading a charge to cut the budget and wants the majority of savings to be found in cohesion funds, while maintaining spending on the CAP (which will please France and Germany). This will be fiercely resisted by newer, poorer member states from central and eastern Europe.