Monday, May 14, 2012

Eurozone: Start of the rebalancing act

Tonight’s Eurogroup meeting could be the prelude of another intensive meeting marathon for the Eurozone, trying to rebalance the crisis management.

When Eurozone finance ministers meet tonight for their regular Eurogroup meeting, they will have a lot to talk about: It is the first meeting after the French and Greek elections, and the first official get-together in the Eurozone’s new discussion on growth versus austerity. Moreover, finance ministers are likely to discuss latest developments in Spain and, more broader, the economic outlook for the Eurozone.

Last week, several European politicians (not only Germans) recalled the need for fiscal consolidation and stressed that the fiscal compact had already been signed by government leaders. In our view, what currently looks like a clash between growth-fanatics and austerity-fetishists will eventually end in a good European compromise with something for everyone: the fiscal compact and the medium-term goal of balanced budgets should remain intact but complemented by a new growth compact with European funds and initiatives. However, even a growth compact can only support but not replace the ongoing structural reforms.

While eventually the discussion on fiscal and growth compacts could turn out to be less controversial than expected, another discussion is more explosive. The discussion on the time path to bring fiscal deficits back to 3% of GDP. Do not forget, this is not part of the new fiscal compact but of existing European Treaties, the so-called Excessive Deficit Procedure (EDP). This year, three countries will have to bring their deficits down to 3%, next year another eight. According to the latest European Commission forecasts, only four countries would currently reach these targets (BE, IT, DE and AT). The crucial issue of the next weeks will now be whether countries will implement additional austerity measures, receive more time or would eventually be sanctioned for not sticking to the rules.

The European rules are not as strict as often believed. While normally the European rules require countries to return their deficits to 3% one year after the identification of an excessive deficit, a loophole in the rules allows for more time in the case of “special circumstances”. These special circumstances were already applied in 2009, giving most Eurozone countries three to four years to reduce their fiscal deficits. Even if the decision on special circumstances is discretionary and not based on a single indicator, one variable to look at when getting an idea of who could again “qualify” for special circumstances is the output gap. According to the latest European Commission forecasts released last Friday, out of all EDP countries, only the Netherlands and Slovenia are expected to have a bigger negative output gap next year than in 2009. In absolute numbers, negative output gaps would be the highest in Slovenia, the Netherlands and Spain.

At the current juncture, decisions on the 3%-adjustment path will require a lot of fine-tuning and sensitivity. While in our view, more time for fiscal adjustment looks almost inevitable and simple to justify for Spain (with a forecasted deficit of 6.3% next year), the challenge is where to draw the line without undermining the credibility of the entire fiscal framework. How to give more time to Spain, while keeping the pressure on countries like France (with an expected deficit of 4.2% in 2013)?

The high level meetings of the coming weeks are likely to shift the balance towards more growth. However, it will not be easy to balance growth, fiscal austerity and credibility. It is obvious the Eurozone policymakers will need a lot of sensitiveness and finesse to succeed.

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