By Prieur du Plessis, on January 30th, 2012 posted in: Economy, Europe Leave your comment

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The article below is a guest contribution by Cees Bruggemans, Chief Economist of First National Bank.

Last week, the Euro area Purchasing Managers Index (PMI) rose for the second month in a row, topping out above 50, surprising market analysts who had expected 48.

It suggests no EU recession, or at least the possibility of already moving on, bolstered by late last year’s French output data and also this week by German IFO business confidence data (all perking up).

Yet on the very day of the PMI release the IMF released with the usual fanfare its latest world outlook, heavily revising down its global growth forecast from 4% to 3.3% with dire words for Europe.

This greatly added to the creative tension bearing down on that unhappy continent, with the IMF, as so many others, presumably inspired by the thought “why waste a good crisis?”

As usual, though, the IMF was six months late where events are concerned.

This doesn’t mean to say Europe is out of the woods. But the pain is mainly on the plain in Spain and other peripherals. The core EU may have slowed but is not necessarily sinking. As the latter carry the greater weight in the overall picture, it decides the overall colour scheme in the Eurozone.

So while Europe is bad, it is a tad premature for funerals.

Three articles in recent weeks drew attention, by former Fed Vice Chairman Alan Blinder, Bank of Greece Governor George Provopoulos and Portugal’s Carlos Moedas (secretary of state to the prime minister), each in turn emphasising just how very complex and challenging the European makeover is and will be and choices on offer.

In considering this, one should also keep in mind Italian prime minister Monti’s earlier reform announcements, and Spanish prime minister Rajoy’s intentions. The communality and interchangeability between is something to behold.

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George Provopoulos, Governor of the Central Bank of Greece, highlighted a few home truths last week for those perhaps ignorant of what his country is going through and will still face.

It makes for shocking reading. But also, perhaps surprisingly, it makes for possible redemption and not via Euro exits either.

Greece is now in its fifth year of economic contraction, unemployment is surging, fiscal and current account deficits remain large and Greek borrowers are shut out of financial markets.

This is far worse than envisaged under the May 2010 adjustment programme. As Greece negotiates yet another adjustment programme, why did the first one go off track?

Firstly, implementation was slow and inefficient.

Secondly, fiscal consolidation based on spending cuts lead to a smaller economic contraction than ones based on tax increases. Yet Greek measures depended for 60% on tax increases and for 40% on spending cuts.

This mix reduced the incentive of businesses to invest by reducing after-tax returns on investments. Temporary tax increases still hold the economy back by creating policy unpredictability. Tax increases also reduced after-tax income, restraining consumption.

Government spending remained over 50% of GDP, reducing scope for private investment to boost exports and import-competitive goods and generate growth.

Worse, government scaled back public infrastructure investment most sharply, yet it is the key contributor to the country’s future economic growth.

Thirdly, the scale of fiscal cutbacks was large because of the size of the initial budget deficits. Such cutbacks were never going to be easy. Still, they were almost twice as large for Greek households in 2011 as for those in Ireland and more than twice those in Portugal.

Indeed, difficulties in implementing structural reforms, privatisation and measures to improve efficiency of tax collection exacerbated unavoidable pain. As a consequence these fiscal cutbacks led to a greater economic contraction than expected as not all interconnected parts of the programme were in place.

Fourthly, Greece has experienced a much bigger negative fiscal multiplier than other peripherals. Greece has undergone a larger fiscal cutback than Ireland or Portugal, but relative to the size of the cutbacks the economy has contracted more, as Greece is a relatively closed economy (any decline in demand hitting domestically produced goods more than imports).

This decline in demand for domestic production affects output more than if the economy were more open (with a greater share of imports in final demand).

Together these factors have produced a cycle of pessimism, cuts in private spending and negative growth.

Continue reading European choices