Last week’s bailout deal for Greece was not a solution to the eurozone debt crisis. It was simply a debt devaluation – and, no doubt, it will be the first of many. Debt devalua-tions are necessary to provide fiscal relief but they do not improve competitiveness. Supply-side reforms are essential. While there have been important reforms among the peripheral economies over the past couple of years, they have not been sufficient. More important, the payback for these reforms in terms of their impact on productivity and productive potential growth will take several years. This means the focus will remain on competitiveness and te lack of growth among the peripheral economies. But that is not necessarily where the real danger lies.
Last week’s deal and the immediate reaction to it was essentially a reprise of last year, when the first Greek package inspired huge relief in markets which were all too keen to believe the problem had been solved. It had not. Market relief this time will be similarly short-lived – but not because of lingering problems in Europe’s periphery. Indeed, the most important shift over the next few months will be the deterioration of economic conditions within the core economies.
The combination of global economic slowdown in the second quarter, coupled with the ECB’s misguided interest rate hikes – as well as the heightened interest rate and financial market volatility – is expected to lead to further slowdown. The purchasing managers’ indices in Spain, Italy, Ireland, Portugal and Greece are all below the psychologically important 50 level denoting slowing activity. The wide gap between IFO current conditions and expectations indicates that sentiment and, crucially, economic activity, will continue to deteriorate over the summer. Our central view on Europe remains that the sovereign debt crisis with strong growth in core Europe is difficult but manageable as long as politicians continue to extend and pretend, but that all pretence is lost when activity amongst the core economies slows to zero.
Ridding the area of currency volatility solves one problem and creates another: debt volatility. How do you dampen debt volatility? You create a common eurobond. Creating a eurobond makes sense, but only if it is accompanied by strict borrowing rules, otherwise there is little incentive for the countries most in need of fiscal austerity to follow through with politically difficult reforms. What is really required to secure the future of the euro is to establish a single eurozone parliament. Regrettably, I doubt one will ever happen.
Stuart Thomson is chief market economist at Ignis Asset Management