It's the Reforms, Stupid!
Adelina Marini, October 19, 2014
The euro area crisis is getting back judging by the tangible increase of the prices of new debt for the peripheral countries on the financial markets last week. The yields of Italian, Portuguese and Spanish debt have risen by around 30 basic points, but then subsided back to normal. The price of the Greek debt, however, has reached 9% for the first time this year. This outcome was expected against the backdrop of the uneven recovery from the previous stage of the crisis and the renewed debate about the reasons - is it the excessive tightening of belts that stifled investments or is it the lack of reforms that has led to continued piling of debt and excessive budget deficits. Certainly, this debate will accompany the new European semester which is already pushing the tensions high in the eurozone because of France's refusal to abide to the fiscal rules agreed in an attempt to calm precisely the debt markets.
Despite the agreed extension of the deadline for fiscal correction and the European Commission recommendations, France is again planning not to stick to its commitments to reduce the budget deficit. By 15 October all the euro area member states had to present their budgetary plans for 2015. In France's plan, it is foreseen the budget deficit to remain 4.3% of GDP because of the low inflation and weak growth. The French government expects by 2016 an improvement of the macroeconomic climate and therefore to squeeze the gap to 3.8% of GDP with a possible return below the ceiling of 3 per cent in 2017. This has fuelled speculation whether France will be punished as is envisaged in the two-pack (the package of two legislative proposals for enhanced budgetary coordination in the euro area). For now, the European Commission is refusing to comment until it has finished reviewing all the budget plans.
According to the Commission's calendar, it will come up with an analysis of the 18 euro area budgets on 29 October. Jyrki Katainen, the economic and financial affairs commissioner, has refused to comment on whether it is possible the French plan to be returned for rework which would create serious tension between Brussels and Paris, but also in Athens, Lisbon, Madrid and Dublin. The Eurogroup chief Jeroen Dijsselbloem also has refused to comment before the Commission speaks. Problems are expected also with Italy's budget, but according to Jeroen Dijsselbloem, the difference between Italy and France is fundamental - Italy is in the preventive arm of the Stability and Growth Pact, which means that it is only under supervision whereas France is in the corrective arm, i.e. its fiscal policy is subject to correction. Another essential difference is that the new Italian Prime Minister Matteo Renzi is not wasting time but is trying to impose radical reforms on Italy.
There are problems in the entire euro area and in addition to the uneven distribution of recovery, these problems are different in character. The International Monetary Fund (IMF) has revised downward its forecast about the economic development of the currency block from 1.2% to 0.8%. Serious worries causes Germany which surprised unpleasantly everyone in the summer when the data about the second quarter showing its economic growth had frozen. This is a huge blow for the dominated by Berlin economic policy of the EU and a powerful argument in the hands of the opponents of fiscal consolidation (anti-austerians). The situation has deteriorated dramatically with the collapse of one of the best performers in EU - Finland - whose triple A credit rating has been downgraded by Standard&Poor's on 10 October to AA+ because of a continuous period of stagnation and ageing population which is "complicating efforts to balance the budget and reduce debt". Its neighbours Sweden, Norway and Denmark are maintaining their AAA rating.
The lack of reforms is the main reason for the return of the crisis
However, in the euro area only Germany and Luxembourg have remained with triple A rating which, obviously, is not for granted given the problems with the German economic growth. Against the backdrop of this dim picture, the bright stars on the sky are Spain and Ireland. The reason, IMF believes, is that the two countries have implemented large-scale structural reforms which are currently paying back. Phil Gerson, deputy director of the European department of the IMF, explained on 10 October that the Spanish authorities have done many things well. One of them is the recapitalisation of the banking system which happened under a special financial programme funded by the EU. Besides, the government has implemented a painful reform of the labour legislation, improved the public finances and returned the country on the path of stable economic growth. The record high unemployment remains a problem in Spain. This can improve if the government undertakes tax reforms, improves the business environment and continues with reforms, the economist explained.
The focus in the IMF's analysis is that the euro area desperately needs structural reforms to stimulate growth. Nothing different than the pretty familiar reforms that have been discussed for a decade now - applying the Services Directive, reforms of the goods and labour markets and also of the energy market. Most important, however, are the reforms of the labour market, said Poul Thomsen, acting director of the European department of the IMF. "I understand that some of these reforms will be difficult, but I also think that by showing a determination to do these reforms, even if it’s gradual, a strong determination to do these reforms can actually have a relatively important and early impact on growth". However, political support is needed not only in the affected countries but also in the euro area member states. But this seems the toughest part, especially against the backdrop of the attitude in Paris.
In an attempt to come out of the situation, the Finnish government, which until recently was boasting the lessons learnt from the Scandinavian crisis from the early 1990s, tasked the former minister of finance of Sweden, Anders Borg, to prepare a report on Finland's economic situation with recommendations how to restore growth. The report is expected to be completed by the spring of 2015.
Brussels no longer believes in promises
The problems with the uneven recovery were a major topic during the Eurogroup meeting on 13 October and the Ecofin meeting on the next day. According to Eurogroup chief Jeroen Dijsselbloem, there is a broad consensus among the ministers of finance that the current situation is not satisfactory and that strong actions are needed for structural reforms, fiscal policy and investments. Against the backdrop of the growing conflict with France, though, there is a serious change in tone and approach. If until recently the main pillar of the Union's economic policy was fiscal discipline + investments, the new mantra is triple: fiscal consolidation coupled with structural reforms and investments. To this end, the EU ministers of finance have agreed on new measures to boost investments at the centre of which, again, are structural reforms. There is no retreat from the current position that the fiscal consolidation and the battle with high public indebtedness are a foundation for sustainable growth.
While the confirmation of the new European Commission is awaited, whose economic team has an immediate task to develop its own vision of what flexibility is and does it mean allowing large budget deficits until the economy embarked again on the path of growth in full steam, the Eurogroup chief said that higher budget deficits could be tolerated only if the promised reforms have already been passed by national parliaments. The countries that implement structural reforms with a serious impact on the economy in a convincing way will receive additional support for investments, especially in infrastructure. Their efforts will be taken into account when their budgetary plans are reviewed. This Jeroen Dijsselbloem's statement, we can say, marks a victory for Matteo Renzi. From the very beginning he insisted precisely on this type of "flexibility" whereas Germany, the Commission and the Eurogroup including refused with the argument that there is already enough flexibility in the Stability and Growth Pact.
The mysterious 300 billion euro plan
The most important issue that will need an answer to in the coming weeks is where the money will come from to boost reformist states. The most frequently mentioned source of funds is the package of 300 billion euros, announced by the newly elected president of the European Commission Jean-Claude Juncker in front of the European Parliament this summer, which has already turned into mystery. Then he said that his top priority would be to present in the first three months at the helm of the Commission an ambitious package for growth, jobs and investments in the context of the review of the 10-year economic strategy of the EU Europe 2020. This package will cost 300 billion euros. And although Juncker said in Strasbourg that this was additional funding, in fact this has proved the most controversial element of the idea. He explained that the essential part was better usage of the common EU budget and of the European Investment Bank (EIB).
This money should be targeted for investments in infrastructure, most of all broadband and energy networks, as well as transport infrastructure, education, research, renewable energy. There are still a lot of ambiguities in terms of where will the money come from. This emerged as a central issue during Jyrki Katainen's hearing in his capacity as vice president-designate of the European Commission where he will be responsible precisely for this plan. The former prime minister of Finland, is currently a commissioner on the economic and financial affairs. During his hearing in the European Parliament's economic committee, he was literally bombarded with questions about where will the money come from. His explanations made it clear that there was no additional funding but better usage of already agreed programmes.
Beside the EU common budget and the better usage of the EIB, Mr Katainen envisages to involve in the scheme the national development banks, if there are such and if there are not to create them. The main goal, however, should be to boost private investments, not to continue spending public money. He explained then that not the entire amount of 300 bullion euros would be liquidity. Mr Katainen also plans to attract for funding the package the countries that have current account surpluses. The brightest example of such surplus is Germany. The Socialists in the European Parliament remained deeply unhappy with Jyrki Katainen's answers and vowed to reject his nomination during the vote of the entire College at the October plenary session this week, precisely because this package is not about additional money to be injected in the European economy but about further efforts.
In the meantime, the European Parliament has been preparing a draft resolution that will be voted this week in the plenary, calling the Commission to urgently set in motion the 300 billion euro investment programme. The MEPs send strong criticism against the countries that refuse reforms. "[...] finds it regrettable that some Member States in the rest of the euro area lack ambition in modernising their economies, which is one of the reasons for the low sustainable growth prospects in the medium and long term". This is said in the context of the deep reforms that have been implemented by the countries with adjustment programmes. It is interesting whether the spirit of the draft will be maintained in the final resolution because it marks a significant change compared to previous positions of the European Parliament. It is underscored, for example, that the financial and debt crisis, as well as the competitiveness crisis cannot be resolved only through loose monetary policy.
The draft says that the excessive indebtedness of several euro area member states is not only a hurdle for growth but it also creates a huge burden for the future generations. The draft resolution does not mention specific names, which is a blunder. There is severe criticism against the fact that only 10% of the country-specific recommendations of the European Commission have been entirely met last year and 45% have limited or no progress. The European semester and the implementation of the recommendations is an important condition to achieve economic convergence in the monetary union, the draft resolution says. It is based on the report of Philippe De Backer (ALDE), MEP from Belgium.
In end-October, the regular EU summit will take place in the margins of which a euro area summit will take place. The main issue will be how to prevent the return of the crisis. According to Jeroen Dijsselbloem, so far, various tools have been adopted to achieve fiscal consolidation but none supports, induces or boosts sufficiently structural reforms. The leaders should come up with a decision in this spirit because if they allow a compromise for France it will cause a wave of resistance and a weakening of the reforms efforts of the rest. Spain has already hinted that if France is let to get away, Madrid will immediately loosen its own belts and stop the reforms regardless of the fact that currently it is the brightest star in the euro area. France has once been allowed to get away because Germany, too, refused to take responsibility for not applying the Stability and Growth Pact.
After three years of reforms of the EU's economic governance, the toughest phase has begun - implementation. If some of the most influential member states fail in this particular phase, especially after they have imposed or agreed the most affected countries to drink the bitter pill of reforms like Greece, Portugal, Ireland, Spain, everything will be lost, but most of all trust. And then, the crisis will return for good. And it will be much worse then before because it will endanger the very survival of the EU and the currency block. A ray of hope that this time France will not get away is the fact that a key post in the new Commission has been entrusted to the former prime minister of Latvia, Valdis Dombrovskis, to whom the best recipe to exit a crisis is deep structural reforms, implemented fast and in an open dialogue with the social partners and society. This is precisely what is expected of France. The Commission vows that it will treat all the member states equally. Let's hope so.