The eurozone's austerity death spiral

The latest IMF forecast that much of the eurozone will not meet budget deficit targets reflects the circular problem with austerity measures.

The highlight of the IMF updated forecasts was not so much the downgrade to the global growth outlook. The downward revisions to the GDP forecasts for 2012 and 2013 merely took the IMF projections to around the consensus – in other words, a lot of the news has already been factored into markets and the IMF forecasts were just ‘catch-up’.

Rather, the highlight was the confirmation from the IMF that most of the eurozone countries will not meet their budget deficit reduction targets. This was especially the case in those countries experiencing the most severe fiscal problems. In other words, the budget deficits for 2012 and 2013 will be wider in Spain, Greece and Italy than was forecast just three months ago.

This missing of the budget targets reflects in large part a circular problem with the very austerity measures being implemented.

It goes like this. As government’s cut services and spending and hike taxes to address the budget problems, the rate of growth in the economy is undermined. The austerity measures mean that employment, investment and profits are weakened which perversely lowers tax revenue and requires additional government spending.

In other words, the fiscal problem gets worse in the short run before the austerity measures kick in. This is what is happening now.

The IMF update came as Germany’s Chancellor Angela Merkel travelled to Athens to meet with Greece’s Prime Minister Antonis Samaras to discuss Greece’s progress on fiscal and economic reform. The Greek government has for the last two months, been seeking a relaxation of the conditions attached to the fiscal austerity for it to be eligible for bail out funds from the so-called troika of agencies that are overseeing the distribution of funds to countries in financial difficulty.

The meeting wound up with Merkel trying to reassure markets that progress was being made. Merkel said that "Germany will try to solve the problems together with Greece”, adding that "the two nations are working closely together”.

Merkel, acutely aware of the domestic political problems with the Greek economy in its sixth year of decline with unemployment near 25 per cent, tried to offer reassuring words. Merkel said, "I have not come as a task-master and nor have I come as a teacher to give grades. I have come as a friend to listen and be informed."

As she was speaking, there were ongoing protests in Athens that were squarely directed at the Germans who have been recalcitrant in some of their actions surrounding the ECB bond purchase program and other economic rescue measures.

In an effort to temper this perception, Merkel added, "I come from East Germany and I know how long it takes to build reform". She added, "the road for the people of Greece is very
tough, very difficult, but they have put a good bit of the path behind them. I want to say you are making progress!"

Markets were clearly non-plussed with the Euro falling around 1 per cent to 1.2870, while most European stocks were down 0.5 to 1 per cent. This is a disconcerting reaction when there is so much to be done and when economic growth is the best solution to the sovereign debt problems.

This negative market reaction was despite Merkel repeating her reassuring words that Germany wants "Greece to stay in the Euro”, noting that "much has been done – the reforms will pay off”.

The market skepticism seems to be a further reaction to Samaras’ ongoing attempts to get a 2 year extension, to 2016, for the implementation of the next round of austerity measures.

Greece needs to further tighten the budget by €13.5 billion to qualify for the additional bailout funds. Samaras, understandably, is reluctant to implement such significant cuts (which amount to around an additional 5 per cent of GDP) with the economy in an economic depression.

In the next few weeks, Greece is hoping to get approval of the next installment of €31 billion (around 14 per cent of GDP) of bail out funds.

It has been assumed that these funds will be paid, Greece will comply and that for the short term at least, the eurozone will hang together. It is doesn’t, the market reaction around the
world will be savage.


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