Given that the euro-zone economy has fallen back into recession, what is your near-term outlook? When can we expect to see a recovery taking shape?
We will probably start to see positive GDP growth rates by the second half of the year, and perhaps closer to the end of the year. That is my base case, but it’s a close call — it has a 50% probability of occurring. A euro-area recovery must be driven by improving conditions in Spain and Italy. I don’t believe Germany can do all of the heavy lifting. The best assessment I can make of these economies is that they are beginning to stabilize and the recession will probably not worsen. What I am watching for is a turning point in the Spanish and Italian economies over the next few months. If it doesn’t happen, it will be very difficult for the euro area to exit the recession in 2013.
How serious are the problems in Spain and Italy, and how do they differ?
The recession is very different in Spain than it is in Italy. Spain has been affected by a housing market downturn that is still ongoing — but the positive story is that exports are doing very well. Spain’s export performance has been almost Germanlike in terms of its recovery. So any signs that Spanish exports are faltering would be worrisome for the entire euro area.
In Italy, the downturn has been exacerbated by fiscal austerity, which I think is coming to an end this year. The other headwind for the Italian economy has been a credit crunch, which seems to be worsening. I want to see signs that the credit crunch is abating over the next couple of months before becoming more confident that the Italian inflection point is near. Most of core Europe is doing reasonably well, with the exception of France. There, officials are pushing ahead with fiscal austerity at a fairly rapid pace compared to what they’ve done in the past.
We just witnessed a banking crisis in the tiny island nation of Cyprus. What is the significance of that bailout and are you concerned that it may have set an alarming precedent?
Compared to other euro-area economies Cyprus had a huge banking sector, with total bank deposits that were several times the country’s annual GDP, and where there were so many foreign deposits in so many banks. In that sense, Cyprus is a special case. Could things have been done differently? Yes, but I think we have learned by now that politics in Europe are messy and not very well communicated. Policymakers think very pragmatically.
The fact that bonds and other assets have not reacted much to the events in Cyprus or the fractious election in Italy is signaling that market participants believe the European Central Bank’s “ring fence” is doing what is necessary. ECB leaders promised, under certain conditions, to buy up government bonds, essentially putting a safety net under the European sovereign debt markets. That has helped tremendously in terms of assuring investors that the integrity of the euro area will be preserved. There is a strong perception in the market that the ring fence — the “do whatever it takes” pledge of ECB President Mario Draghi — will keep the euro area together.
Why do you think the ECB’s ring fence has not been tested by the markets?
Last summer, the market consensus was that Spain would be forced into taking a bailout package within a matter of weeks, perhaps months. There are two reasons that has not happened. The first is that Spanish growth has been a little bit better than many people had expected. The other reason is that there is a lot of liquidity in the market due to the easy monetary policies of the Federal Reserve and, more recently, the Bank of Japan. Liquidity has to find a home. The search-for-yield strategy is naturally pushing investors into Italian and Spanish government bonds.
On the one hand, we have so much liquidity that it is pushing up asset prices — but on the other hand, we have a credit crunch in Europe. What is your interpretation of that paradox and can it be undone?
Within the euro area we had a Greek government debt restructuring; we had debt crises that re-intensified in Italy and Spain; we had doubts about the survival of the euro area itself. We had a full-fledged sovereign debt crisis in Europe that hit the banking sector extremely hard, for the simple reason that the link between European sovereigns and the banks is as strong as it has ever been. It is this relationship between European governments and European banks that has played out from 2011–2012 onwards. We are still feeling the aftershocks of that.
The way out of this is to break the link between the sovereigns and the banks. European government debt is not on a sustainable track. There is not enough confidence among investors, or even private citizens, that if banks run into trouble, they can be bailed out by the government.
There is a plan under discussion to create a European banking union that, with a little bit of imagination, looks like the U.S. Federal Deposit Insurance Corporation. It would feature a mechanism to close down banks that are insolvent, and may provide for cross-border deposit insurance. It would have, we hope, some funds coming from the surplus countries of the euro area to help countries in Southern Europe if they need to recapitalize a bank. If this plan were fully implemented, I think we would see the European banks unlink from the sovereigns. The problem is that the plan is being implemented slowly and markets may not be patient enough to wait.
Euro-Zone GDP and Unemployment, 1999-2013
Do you see any problems that could derail the progress made so far? What about politics?
The bigger problem is that the ECB can only do so much. The other side of the European debt crisis solution has to come from politicians. We have to acknowledge the amount of institutional change that has taken place in the euro area over the past 18 months. There has never been a time when so much institutional reform has been delivered: closer macroeconomic surveillance, the European Stability Mechanism (ESM), the plans for banking union. The amount of work that has gone into these reforms and how quickly they have been drawn up and are being implemented is extraordinary.
Yet it is two steps forward and one step back. We have seen a little bit of backtracking: what happened in Cyprus is raising questions about how serious European policymakers are about implementing banking union. That’s the most serious problem. There is some complacency around structural reforms at the moment, and some policymakers in Northern Europe are questioning the need for debt relief in Greece. They are also questioning the need for further political integration. It’s the political leg of the European debt crisis solution that I doubt is as strong as it was a year ago. From an investment point of view, it’s very difficult to anticipate what comes next.
And that is the problem not just around Cyprus, but the whole European debt crisis. There has not been one template for all the bailouts. Each bailout has been treated differently.
On a structural level, what worries me is unemployment rates of more than 20% in several of the southern European countries. We’re probably looking at another five to 10 years before unemployment rates in these countries return to what we consider normal levels. This is, of course, a human tragedy and a policy error. I really hope that this crisis has told policymakers that, if you are in the European Monetary Union, there are rules for implementing structural and labor market reforms, and they need to be followed.
European Central Bank Liquidity Operations, 2010–2013
Why do you think European equities have done so well at a time when the economy is struggling?
ECB President Draghi’s pledge last summer effectively took away the risk of a euro exit and had a very powerful effect on share prices, including those of European banks. The price movement we’ve seen in the first quarter of the year is still very much a continuation of that.
For European stocks to make further gains, investors will want to see a strong signal that a recovery is underway. When that happens, I think it will provide a very positive tailwind for European share prices, especially since there are still large segments of the market that have been beaten down since 2008. That reflects recession fears and worries about exiting the monetary union. And it probably also reflects that people have not sufficiently discriminated among companies inside the euro area. From an investment point of view, there should be some very interesting opportunities in the next couple of years if we see some signs that we are turning the corner.
Germany has been both a locomotive of the European economy and a beneficiary of the euro zone. Do you see any potential for policy change following the elections scheduled in September?
Euro-area membership is very much the cornerstone of German foreign policy. It is the narrative of the German economic recovery and I don’t see any change in that story regardless of who wins the election. I think what’s more interesting is how a new government changes the fiscal policy stance of Germany. In my view, German authorities are very focused on debt reduction and setting an example for the rest of the euro zone, and I don’t see any of the major parties favoring any kind of significant fiscal stimulus.
With the recent death of former British Prime Minister Margaret Thatcher, do you think there is any sentiment that perhaps she was right to keep the U.K. out of the euro zone?
It is quite clear from my vantage point in Britain that she left a wide-ranging legacy, both in terms of the economic policies she put in place, and also in terms of Britain’s stance toward the European Union. I think if Margaret Thatcher looked at where the European Monetary Union is today, she would be pretty content that Britain made the right choice. The British view has always been that the British business cycle is not in sync with the euro-area business cycle. The British cycle is still synchronized with the United States, so from a British point of view, it made very little sense to join the monetary union.