What to ex­pect in 2016:

Po­lit­i­cal will to pre­serve Eu­ro­zone re­mains strong Re­cov­ery has ar­rived, but growth is well be­low pre-cri­sis trend The ex­ter­nal risks are sig­nif­i­cant, too

Financial Mirror (Cyprus) - - FRONT PAGE -

In an­tic­i­pat­ing macroe­co­nomic con­di­tions for the Eu­ro­zone in 2016, three themes are rel­e­vant. The first is that the po­lit­i­cal will to pre­serve the Eu­ro­zone, and to deepen Euro­pean eco­nomic in­te­gra­tion, ap­pears to be as strong as ever. Since the start of the Eu­ro­zone debt cri­sis in 2008, this po­lit­i­cal will has been un­der­es­ti­mated. This also largely ex­plains why dur­ing the cri­sis DBRS main­tained its sov­er­eign rat­ings on Italy, Spain, Ire­land and Por­tu­gal higher those of other credit rat­ing agen­cies.

Dur­ing the cri­sis DBRS down­graded th­ese rat­ings, but no lower than ‘Sin­gle A (low)’ in the cases of Italy, Spain and Ire­land, and no lower than ‘BBB (low)’ in the case of Por­tu­gal.

There is some ev­i­dence to sup­port the the­ory that the more Europe is tested, the greater the im­pe­tus to deepen in­te­gra­tion. In­te­gra­tion is in fact pro­ceed­ing in both fis­cal pol­icy and fi­nan­cial pol­icy. The Euro­pean Com­mis­sion has a man­date to im­pose sanc­tions on coun­tries that do not ad­here to the Sta­bil­ity and Growth Pact. How­ever, the treat­ment of mem­ber states’ bud­gets is com­plex and al­lows for sig­nif­i­cant ex­cep­tions to the rules. For ex­am­ple, the Com­mis­sion’s Novem­ber 2015 as­sess­ment of the mem­ber states’ 2016 draft bud­getary plans per­mits higher in­cre­men­tal spend­ing linked to un­usual events out­side the con­trol of the gov­ern­ment, such as the ex­cep­tional in­flow of refugees. How­ever, only some mem­ber states have in­cluded the net ex­tra costs of the refugee cri­sis in their draft bud­getary plans. While greater fis­cal flex­i­bil­ity may be ap­pro­pri­ate to ac­com­mo­date cycli­cal down­turns or un­ex­pected shocks such as the in­flux of refugees, the ap­pli­ca­tion of the rules is un­clear.

To en­force over­sight, the forth­com­ing Euro­pean Fis­cal Board will co­or­di­nate the mon­i­tor­ing of na­tional bud­gets with na­tional fis­cal coun­cils. Pre­sum­ably, this should im­prove the mon­i­tor­ing of mem­ber states’ bud­gets, and could re­sult in greater con­sis­tency of the ap­pli­ca­tion of the fis­cal rules across mem­ber states.

Greater in­te­gra­tion is also oc­cur­ring with the bank­ing union. The su­per­vi­sory pil­lar is in place and the res­o­lu­tion mech­a­nism is be­ing im­ple­mented. As of Jan­uary 1, 2016, all mem­ber states will ap­ply a sin­gle rule­book for the res­o­lu­tion of banks and large in­vest­ment firms as part of the Bank Re­cov­ery and Res­o­lu­tion Di­rec­tive. The BRRD re­quires share­hold­ers and cred­i­tors of banks to con­trib­ute to the costs of a fail­ing institution through a bail-in mech­a­nism. Al­though this could dis­suade in­vestors from pur­chas­ing shares or bonds, th­ese rules are nev­er­the­less likely to make the wind­ing down of a bank­rupt fi­nan­cial institution more pre­dictable.

The Eu­ro­zone’s evolv­ing fi­nan­cial back­stop, in the form of ECB mon­e­tary ac­com­mo­da­tion and the sup­port fa­cil­i­ties, is fur­ther ev­i­dence of will­ing­ness to pre­serve the Eu­ro­zone. The ECB’s ex­tra­or­di­nary mon­e­tary ac­com­mo­da­tion has been the sin­gle most im­por­tant fac­tor in sta­bi­liz­ing the re­gion, from the Se­cu­ri­ties Mar­kets Pro­gram to the prom­ise of Out­right Mon­e­tary Trans­ac­tions – Gov­er­nor Mario Draghi’s July 2012 state­ment that the ECB would do “what­ever it takes to pre­serve the Euro” – to Quan­ti­ta­tive Eas­ing (QE). The EFSF and ESM fi­nan­cial back­stops rolled out since the first sup­port pro­gramme for Greece also demon­strated this will­ing­ness. Th­ese pro­grammes may not have nec­es­sar­ily re­stored debt sus­tain­abil­ity in all cases, but they did stem the panic and pre­vent con­ta­gion to other coun­tries. The preser­va­tion of Greece and Cyprus as mem­ber states in the Eu­ro­zone fur­ther demon­strated this will­ing­ness.

The sec­ond theme is that the re­cov­ery has ar­rived, but GDP growth is well be­low the pre-cri­sis trend. The IMF’s Oc­to­ber World Eco­nomic Out­look GDP growth pro­jec­tions ap­pear to be rea­son­able: the IMF expects the world econ­omy to grow by 3.1% this year and 3.6% next year, while in the Eu­ro­zone growth is ex­pected at 1.5% this year and 1.6% next year. In the third quar­ter, the Eu­ro­zone grew 0.3% quar­teron-quar­ter, slow­ing from 0.4% in the sec­ond quar­ter. Yearon-year, the Eu­ro­zone grew 1.6%, slightly higher than 1.5% in the sec­ond quar­ter. As Ex­hibit 1 shows, the United States and United King­dom are grow­ing well above their pre-cri­sis peak; the EU has just sur­passed it; the Eu­ro­zone and Ja­pan not quite. This is an un­even pic­ture, and the un­cer­tain­ties fac­ing the Eu­ro­zone present down­side risks to growth.

In­deed, it is doubt­ful that the Eu­ro­zone has emerged stronger af­ter the cri­sis. When the out­put gap closes, it is likely to do so at a lower level of out­put. As Ex­hibit 2 shows, the dot­ted black line rep­re­sents the slope of po­ten­tial GDP as it would have been had the cri­sis not occurred; the yel­low line is the new pro­jected rate of growth of the econ­omy; the blue line be­low is the ac­tual rate of growth. The out­put gap – the gap be­tween the blue line and the yel­low line – is ex­pected to close at a lower level of out­put than it would have given the orig­i­nal pro­jected po­ten­tial GDP. By one mea­sure, the loss to po­ten­tial GDP for a se­lec­tion of 22 ad­vanced economies is 8.4% be­low the pre-cri­sis path would have pre­dicted.

The ques­tion is, why has trend growth de­clined? One would ex­pect a re­bound in ex­ports given the weaker ex­change rate, higher consumption and in­vest­ment from lower world oil and com­mod­ity prices, and greater consumption and lend­ing from low in­ter­est rates be­cause of bond pur­chases by the ECB. How­ever, do­mes­tic de­mand has yet to re­bound in a more ro­bust man­ner. The most con­vinc­ing ar­gu­ment for why growth in the Eu­ro­zone is so far be­low po­ten­tial is the “sav­ings glut” ar­gu­ment – “sec­u­lar stag­na­tion” – or the ten­dency for de­mand to be weak rel­a­tive to po­ten­tial sup­ply.

Weak do­mes­tic de­mand, sup­ply side con­straints, and po­lit­i­cal frag­men­ta­tion may all be con­tribut­ing to this phe­nom­e­non. De­spite some signs of a pickup in consumption, both consumption and in­vest­ment re­main lack­lus­tre. This de­fi­cient do­mes­tic de­mand is at least partly the re­sult of delever­ag­ing gov­ern­ments, house­holds, non­fi­nan­cial cor­po­ra­tions and banks. In such an en­vi­ron­ment, it is no sur­prise that spend­ing is lower. Sec­ond, with low in­vest­ment, es­pe­cially pub­lic in­vest­ment, labour pro­duc­tiv­ity has de­clined. Ex­hibit 3 shows that the la­bor pro­duc­tiv­ity growth that is at­trib­ut­able to in­vest­ment has de­clined sharply in the G7 coun­tries – not only in the US, the UK and Ja­pan, but also in Ger­many, France, Italy and Spain. There­fore, this is a world­wide phe­nom­e­non. With lower pro­duc­tiv­ity comes lower growth.

Sec­ond, there are sig­nif­i­cant sup­ply side con­straints. One sign of this is in per­sis­tent un­em­ploy­ment, which is af­fect­ing hu­man cap­i­tal. For long-term un­em­ployed, in­ac­tive or dis­cour­aged work­ers, their ad­verse ex­pe­ri­ence may neg­a­tively af­fect their at­ti­tude to­ward work, as well as their ap­ti­tude for work. The risk is that in the event of per­sis­tent low growth, or worse, a se­vere down­turn, the bad cy­cle might per­ma­nently dam­age the trend. An equally im­por­tant sup­ply side con­straint is slug­gish credit growth. In spite of QE, which has kept bond yields low and ex­panded the ECB’s bal­ance sheet, credit growth to house­holds and non-fi­nan­cial cor­po­ra­tions has been lim­ited.

A third pos­si­ble rea­son for low growth is po­lit­i­cal frag­men­ta­tion. There have been sev­eral lay­ers of frag­men­ta­tion. Aus­ter­ity fatigue and other fac­tors are re­sult­ing in the splin­ter­ing of tra­di­tional cen­trist po­lit­i­cal par­ties, and this is draw­ing main­stream politi­cians to the

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