But, while suggesting speed limits for fiscal profligacy (structural deficits to be capped at 0.5% of GDP, and headline deficits at 3%), the proposals are not binding, and still look more a political compromise than the economic solution the eurozone needs.
No credible plan
Even if credible, they will be no panacea. First, by seeking fiscal deficits significantly below current levels – but offering no obvious growth plan to get there – the changes would address only future crises.
Deficits in 2011 will have ranged from near balance (Estonia) to over 9% of GDP (Greece). Spain admits its 2011 deficit will be closer to 8% of GDP than its 6% target.
Second, ratifying the proposals by March looks optimistic, especially where there are new administrations or elections (Spain, France), and where the smallest countries (Slovenia) are averse to cutting their growth to help bigger ones (Greece). In which case, S&P’s own March deadline will be tested, triggering downgrades for Germany, France and the four other AAA-rated sovereigns, and further undermining the EFSF.
The biggest challenge, though, will be to appeal to Germany’s hawkish principles, and yet head-off the economic and market tensions now spreading to the core members like Germany and France. We expect the ECB to ultimately capitulate on QE, but not soon enough to stave off the pressures converging to the core. But, to sanction a sizeable expansion of the ECB’s balance sheet, the Bundesbank and German government will need more evidence of its own economic and financial conditions imploding.
The economic deterioration has started. Activity levels are becoming so stunted that recession looks inevitable. Even if a common eurobond follows, haircuts on orderly defaults will probably just crimp growth further.
The ‘haves’ and ‘have nots’ still exist
And, fourth, even if the EFSF/ESM plan works, it would simply take us back to the problem – disparate competitiveness. As a bloc, the eurozone has become steadily less competitive with the euro, only part of which can be laid at the weak US dollar’s door. The zone’s unit labour costs have risen a hefty 21% relative to its trading partners, contributing to an erosion of its current account position, not helped by oil. By contrast, the US’s have fallen 38%; the UK’s by 11%.
But, within the zone, there have been widely disparate shifts in competitiveness. The deciding factor is whether members do or don’t undertake the cost adjustment necessary given the devaluation route is closed off.
The biggest winners include Germany – important given it accounts for about one-third of eurozone GDP. But, most members have experienced deterioration. While Germany has managed to cut its relative unit labour costs by over 1%, Spain and Italy have seen theirs rise a whopping 23% and 35% respectively. Their competitiveness has deteriorated fastest of all members. Ireland has had to suffer deflation to ‘improve’ its position.
This reminds us of the cause of the tensions – arising from a monetary union, with some political union, but nowhere close to enough economic union.
So, more structural reform will be needed from fiscally erring members like Spain, already grappling with soaring unemployment. Judging by the progress so far, this may need years of austerity and low growth – keeping a dark cloud hanging over the US, UK, and China.
Meantime, outright monetisation will need the ultimate capitulation from a German government yet to fear the deflation risk ahead. In which case, the euro will for some time yet have to remain a currency ‘in search of’ a government.
