Industrial production slumped 1.8% in the final quarter of 2012 from the same 2011 period. The economic contraction in Spain (as in Italy) is a direct result of strict austerity policies. The Spanish government is slashing government spending in order to reach eurozone-imposed, deficit-reduction goals. Spain’s budget deficit ratio, which was 9.4% of GDP in 2011, dropped to 6.3% in 2012, and the aim is to hit 4.5% this year and 2.8% in 2014.
The data for Spain and Italy highlight the problems. “The financial markets are signalling a bright outlook, but the reality in terms of growth currently is far from that,” says Allen. Eurozone growth forecasts call for recession for the next six months to a year, then a switch over to growth. “The problem is that these growth forecasts have been drastically wrong. Greece is the classic example. When they started with the bailout program, the projections were that there would be a similar trajectory. That, of course, is not what happened, and we have had five years of contraction.”
Italy could “well get into a downward spiral like Greece,” Allen says. The ECB’s Fiscal Compact Treaty, as in the case with Spain, will be a long-term drag on growth because it requires Italy to slash its debt by more than 3% of GDP for many years. As the country’s economy and thus revenues shrink, it then has to cut even more, “and this will be problematic. The recent problems and the bailout of Monte di Pascua di Siena [an Italian bank] illustrate there are a lot pitfalls along the way as the economy starts shrinking. Italy hasn’t grown significantly for a long time. It’s not clear what policies will create growth.”
The austerity policies being vigorously pursued in much of the eurozone increasingly are being questioned, including by the International Monetary Fund (IMF), which recently acknowledged in this Working, titled “Growth Forecast Errors and Fiscal Multipliers,” that too much austerity can damage GDP growth during a debt-deflation recession such as we have now by a factor of two or three times more than previously thought.
This is a huge concession and suggests that the current approach of using austerity for debt reduction may be self-defeating. In its most recent update of its World Economic Outlook, released January 23, the IMF forecast that while the world economy overall was likely to grow by about 2% this year, the “euro area continues to pose a large downside risk to the global outlook,” as does “excessive near-term fiscal consolidation in the United States.”
Guillen agrees that austerity policies have outlived their usefulness. “Germany seems fixated on this idea [of austerity]. They are balancing their own budget, although the markets are not demanding that. In the periphery, austerity means a prolonged recession and high unemployment for a longer period of time. I’ve said many times there is a middle-of-the-road solution that doesn’t negate the need for fiscal rebalancing while avoiding a long slump.” Germany should raise wages, which would stimulate troubled euro economies; the ECB should raise its inflation target, which would help to alleviate debt burdens more generally; and the surplus economies should engage in fiscal stimulus.
Italy’s current economic indicators, which help clarify what is happening in the eurozone more generally, are “very worrying,” says Allen. “It’s not clear they are on a sustainable path. They may well follow Greece. If that happens … the EU can’t bail them out.” So while it is possible that the ECB “may start monetizing the debt, this will require a large increase in their balance sheet. Not only will they effectively need to finance the Italian government but also the Italian banks. The other options will be to default or to leave the eurozone or both. None of these outcomes is good. ”
Many observers now think the ECB ultimately will weaken the euro considerably in order to stimulate the economy, Allen says. But such measures involve big risks. “We don’t know the possible long-term effects of these kinds of policies. My own view is still that the eurozone needs an exit mechanism for extreme problems. They avoided setting it up with Greece because they could fudge the numbers. But this was a mistake because if Italy has to leave, there will probably be significant contagion.”
If it is true, as more and more observers believe, that austerity now is causing more problems in Europe than it is solving, why can’t Europe’s leaders see that?
Politics and pride are preventing a clear view, says Allen. “The systems they have put in place haven’t worked, and they don’t want to admit this. They may muddle through. But the human cost is tremendous. Unemployment will probably go up significantly in Italy going forward. It is already unacceptably high in Spain and Greece, particularly youth unemployment.”
These societies are already undergoing tremendous social unrest under today’s stark economic conditions. How long can Europe go before there is a major political or economic breakdown, something far worse than we’ve observed so far? “We will see how much people will take,” Allen says. “The extreme parties are losing votes at the moment. But if growth doesn’t happen soon, this could change quickly.”
