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Economics Weekly - Can the Euro-zone survive the Greek tragedy? Weekly economic data preview - Concerns over outlook to overshadow upward revisions to Q1 GDP

Economics Weekly 24 May 2010


Can the Euro-zone survive the Greek tragedy?


Can the euro-zone survive the crisis of confidence that is currently washing over the peripheral highly-indebted countries of Europe? That is the question that speculators are now daring to ask, as the fiscal crisis in Greece threatens to spill over into Spain, Portugal, Ireland and Italy. After a decade of relative stability, policy-makers across the single currency area are now being forced to address the gaping fault-line that has been exposed in the EMU architecture – namely, whether a credible economic and monetary union can be sustained without credible and binding fiscal arrangements as well.


Arguably, it has been the lack of any binding fiscal commitment that has led to the moral hazard and hence the problems that now threaten to destabilise the region. The problems that erupted in Ireland in 2007 and 2008 provided an early warning of the vulnerabilities that the smaller more high-indebted countries faced. To its credit, Ireland was quick to respond to the challenge, adopting an unprecedented fiscal austerity package in late 2009, including painful cuts in public sector wages and pensions. Although early days, there are grounds for cautious optimism that this fiscal austerity program is working. As the civil unrest in Greece has highlighted, however, not everyone is so accepting of swingeing fiscal restraint, particularly when that restraint follows an unprecedented economic downturn they believe is not of their making.


If the crisis of confidence was confined to Greece, the problem would be discomforting, but manageable. Although Greece’s public sector debt has soared to 120% of its national output, it contributes less than 3% towards the Euro-zone’s economic output. If it were an isolated incident, Greece would be forced to address its fiscal profligacy on its own – even if that ultimately led to debt restructuring or, in extremis, default. The problem, of course, is that the problem now threatens to become a systemic crisis, as other highly-indebted countries of the single currency area have been swept up in the ensuing malaise.


It is the systemic nature of the crisis that has forced, albeit belatedly, the European Union’s hand. The recently announced rescue package put together by the EU and the IMF could potentially reach €750bn - sufficient in size to address the financing needs of Greece, Spain and Portugal for the next three years. The package comprises €440bn of loans and guarantees by the Euro-zone countries (with risk shared amongst the member states on a prorate basis according to their gdp shares), EU wide support of another €60bn and an IMF contribution of €250bn. On top of this, and perhaps most importantly, the ECB has stepped into the fray, with its commitment to buy the European sovereign bonds of the beleaguered countries, albeit on a sterilised basis. So far, the purchases it has undertaken have been relatively small, totalling less than €20bn.


So will the package be sufficient to put the region back on an even keel? Judging by the initial reaction, the markets remain unconvinced. After a brief rally, sovereign credit spreads across the highly-indebted nations of Europe have started to rise again, and the euro has come under renewed downward pressure. The decline of the single currency has been startling. Since reaching $1.51 last December, the euro has dropped by nearly 20% against the US dollar, accumulating a loss of 8% over the past month.


In the midst of the current turmoil, it is easy to conclude that speculators will continue to have the upper hand. But this risks underestimating the resolve of the core EU member states and the ECB to end this crisis. In particular, the ECB has the ability to act as a monopoly purchaser of Euro-zone government debt on either a sterilized or, in extremis, unsterilised basis.


The latter would represent a policy of quantitative easing – something the ECB has so far steadfastly opposed given its desire to maintain its hardfought anti-inflation credibility. Nevertheless, as the Bank of England and US Federal Reserve have already clearly demonstrated, an expansion of base money can be a price worth paying to foster stability.


At this stage, however, it remains unclear whether the ECB will need to embark on this strategy. While Greece faces the very real possibility of default, the economic and fiscal fundamentals of the other member states that have been swept up in the crisis are not as poor.


In sum, therefore, we are cautiously optimistic that the global markets and the afflicted European countries themselves will be able to ride out this storm. The economic, social and political capital invested in ensuring the success of the euro and the stability of its member states far outweighs the fiscal problems currently afflicting the region.


While there has been some speculation that Greece may be forced to exit the single currency if its crisis worsens, it is difficult to conceive of a set of circumstances in which this would be either in the interests of Greece, or the other EMU member states. The cost of exit for Greece would almost certainly exceed the costs of adhering to a fiscal austerity program, not least since Greece would face the added burden of having to repay its share of euro-denominated debt in what would almost certainly be a significantly depreciated domestic currency.


Moreover, the euro zone was built on the idea of bringing together nation states to create a single, permanent economic and social union. While recent events highlight the difficulties of achieving this task among a range of disparate countries, the economic, social and political costs that would likely be incurred by the other member states from ejecting Greece would likely far exceed the short-term benefits of the expulsion.


As the battle of wills between EU policy-makers and the international investment community continues, European asset markets and the euro are likely to remain highly volatile. Nevertheless, over the medium term, we believe the euro will again find a more solid footing. In the meantime, the depreciation of the single currency should help to provide a cushion to the economic challenges the region is now facing.


Adam Chester, Senior UK Macroeconomist



Weekly economic data preview 24 May 2010


Concerns over outlook to overshadow upward revisions to Q1 GDP


􀂄 The past week has been dominated by losses in stock and commodity markets in the wake of Germany’s unilateral decision – via the Federal Financial Supervisory Authority (BaFin) - to temporarily ban the so-called ‘naked’ short-selling of certain types of euro-zone debt and credit default swaps, along with selected German financial stocks. Adding to the tension have been comments from Chancellor Angela Merkel to the effect that the current sovereign debt crisis means the future of the euro itself is at stake. That the decision to ban naked short-selling was unilateral suggests a domestic political motive. Germany has approved its (€150bn or so) share of the recently-announced €750bn EU-led rescue package, though many German taxpayers remain angry. Unless euro-zone members can present a united front when attempting to tackle the debt crisis, the usefulness of the €750bn ‘backstop’ package has to be questioned. A high degree of financial market volatility looks almost certain to persist for the foreseeable future. In terms of euro-zone economic data, this week’s highlights include preliminary May CPI data for Germany, along with business confidence data from both France and Italy. On inflation, we look for German price pressures to have picked up to 1.2% in the year to May, compared with 1.0% previously. Euro area business sentiment, meanwhile, has held up well thus far on improved export sentiment (particularly Asian demand for euro-zone exports). However, recent turbulence in financial markets means we look for flat readings for both the Italian ISAE and French INSEE surveys.


􀂄 It is a quiet week for key data in the UK. The highlight is the second estimate of Q1 2010 GDP on Tuesday, with recent figures - most notably March industrial production and last Friday’s business investment data - suggesting a modest upward revision to 0.3% for output growth from 0.2% previously. The first expenditure breakdown will also draw attention, with the prospect that consumer spending declined again after registering its first gain for seven quarters in Q4 2009. Other releases include: BBA lending (Tuesday), CBI distributive trades (Thursday) and Gfk consumer confidence (Friday).


􀂄 This week’s US data are expected to confirm that the recovery remains on track. We look for durable goods orders excluding transportation equipment to rise modestly in April, on the back of robust gains in the previous two months, as confidence improves. Resilient consumer spending has been key to the recovery, contributing 2.6 percentage points of the 3.2% annualised gain in Q1 2010 GDP – the second estimate of which will be published on Thursday. We forecast

data on Friday to show personal spending rose by 0.3% in April, extending the run of monthly gains to seven and putting up an important marker for Q2 GDP. This release will also provide the latest estimate of the Fed’s preferred inflation gauge, the core PCE deflator, which we predict dropped to 1.2% in April. Prospects for consumer spending hinge heavily on labour and housing market conditions. We expect Thursday’s initial jobless claims to reverse the previous week’s surprise increase, potentially falling to the lowest level since August 2008. Existing and new homes sales, on Monday and Wednesday, respectively, are projected to show a further gain. The improvement in general economic conditions should be reflected in a stronger outturn for consumer confidence on Tuesday, although recent events in Europe represent a risk. This week also sees a host of Fed speakers including Chairman Bernanke, while Treasury Secretary Geithner will be in Europe. The US Treasury will auction $113bn of notes as part of its quarterly refunding exercise.


Jeavon Lolay and Mark Miller



Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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