Last week was an extraordinary week by any standards. The economic forecasts produced by the Office for Budget Responsibility to accompany the Autumn Statement were truly shocking. The growth projections to 2013 were revised down significantly and the public finances, deficits and debt, were substantially revised up. The OBR concluded however that both the fiscal mandate (which relates to the removal of the structural current deficit on a 5-year rolling basis, currently by FY2016) and the supplementary target (which relates to achieving a fall in the debt/GDP ratio by FY2015) were met. But they only met by some rather fancy figure-work in the forecasts. A happy combination of buoyant GDP growth and tough public spending cuts in FY2015 and FY2016 delivered the “right result”. The probability of achieving this fortuitous combination of events strikes me as close to zero. Nevertheless the financial markets, somewhat distracted by events across the channel, appeared well satisfied with the Autumn Statement and the Chancellor should be congratulated for sticking to his plans.
Tellingly the OBR’s forecasts were based on the assumption that the Eurozone would muddle through and not implode. The OBR said with admirable constraint “…the possibility of a more disorderly outcome represents a significant risk on the downside to our forecast, but one that is impossible to quantify in a meaningful way given the range of potential outcomes.” There could therefore be a “much worse outcome” for Britain. The OBR’s approach is quite understandable and it is difficult to see what else they could have done under the circumstances.
But we should keep a possible collapse of the Eurozone and its economic implications for Britain in perspective. The current uncertainty is undoubtedly undermining growth, it is damaging and unsustainable. And whilst the crisis goes on, confidence and growth will continue to be undermined. A resolution, one way or another, is long overdue. The Eurozone’s leaders have really only two basic choices. They either establish a full fiscal union for the euro area or they acknowledge that a major reconfiguration is in unavoidable. In the short-term reconfiguration would of course be economically disruptive. But by lancing the boil and restoring certainty, confidence and growth could then be restored. The notion that a break-up of the euro would mean economic perdition and therefore “must not be allowed to happen” is absurd.
Sir Mervyn King, as if on cue, was so unremittingly pessimistic in his press conference on the latest Financial Stability Report on Thursday that any remnant of optimism about our near-term economic prospects was extinguished. The Eurozone debt crisis had placed Britain in an “extraordinarily dangerous” situation. Commenting on Wednesday’s move by the western world’s major central banks, he made it very clear that this decision was merely to provide much needed liquidity to stressed Eurozone banks. It was not a solution to the underlying solvency problems of the Eurozone countries. That was a job for governments – not central banks.
Sir Mervyn also confirmed that the British authorities, the Bank and the Treasury, were preparing for a “wide array of contingencies” in relation to the Eurozone. The authorities are in good and increasingly crowded company, given the mounting evidence that multinational businesses are already making their own preparations for possible changes within the currency bloc. For an increasing number of observers of the Eurozone debacle it is now a matter of not whether the euro will break up (partially or otherwise) but when.
There will be yet another attempt to “rescue” the beleaguered currency at next week’s EU Summit on 8-9 December, although Chancellor Merkel has already downplayed expectations by saying the meeting will not bring about a definitive solution to the Eurozone crisis, adding that it will take years to overcome the single currency’s problems.
Merkel and President Sarkozy meet on Monday in order to agree on proposals for an EU treaty change, possibly in the form of a protocol to the Lisbon Treaty, which will be discussed at the Summit. A “fiscal compact”, structured to enforce strict budget discipline and debt control throughout the monetary union, will be at the heart of the proposals. The “fiscal compact” is seen by Merkel as one step in the long road towards a “fiscal union”.
There are still significant differences between Merkel and Sarkozy. Merkel wants automatic sanctions for miscreants, enforcement of the rules by the European Court of Justice (ECJ) and a powerful, centralised “budget commissioner”. Sarkozy has yet to be convinced that this bureaucratic takeover is acceptable, preferring “political” control. He also favours an intergovernmental treaty for the EU17 rather than an amendment to the Lisbon treaty to be ratified by the EU27. Some compromise will probably be agreed, with a bias to Berlin, in return for a relaxation in Merkel’s opposition to a more activist ECB. Merkel may be more prepared to see the ECB step up its programme of buying bonds of the highly indebted Eurozone countries.
In the meantime, Eurozone finance ministers agreed last week to leverage the €440bn European Financial Stability Facility (EFSF), doubling its resources but less than trumpeted in October. Eurobonds and/or fiscal transfers remain firmly off the table.
But even with the “fiscal compact” and a more activist ECB the prognosis for the Eurozone is not encouraging. As many have argued before, the Eurozone crisis is fundamentally an economic one. In the southern peripheral economies technocratic and compliant governments are imposing tough austerity packages at a time when the countries are either in recession or entering recession. These countries probably require a devaluation of 30-40% (or the equivalent by way of job-destroying deflation) against Germany in order to correct their lack of competitiveness. They will fail to grow and unemployment will remain high. Short of full fiscal union the economics will continue to tear the Eurozone apart.
Finally may I add some observations from former-Commission President Jacques Delors, one of the main architects of the single currency. He blamed the political leaders who oversaw the launch of the euro for the currency’s woes in a press interview yesterday. He said they turned a blind eye to the fundamental weaknesses and imbalances of member states’ economies. Commenting on those who objected to euro membership on the grounds that the currency without a single state would be inherently unstable, he said “they had a point”. Indeed we did. Indeed we did.