Tuesday, May 15, 2012

Europe's economic nightmare should worry us

FOR Australia to achieve the government's 3.25 per cent growth forecast, and hence a budget surplus, the global economy will have to remain benign. That really depends on what happens in Europe and, week by week, it looks more unlikely.

Europe is far away, and unless you watch the SBS news it has an unfamiliar cast of characters and issues. But this year it will become more and more important in our lives, so it's worth watching and its scene is changing rapidly. Deficits and debt are one half of Europe's problem. Recession and unemployment are the other. The issue is: which should you tackle first?

German Chancellor Angela Merkel, outgoing French President Nicolas Sarkozy and the European Commission insisted that governments must get their fiscal house in order first, whatever the cost to jobs and growth. And so Europe's governments have locked themselves into a pact to bring their deficits below 3 per cent of GDP by 2013.

But as economists such as Martin Wolf of the Financial Times and Paul Krugman of The New York Times forecast, those austerity measures have led Europe back into recession. So deficit targets have not been met, which requires further austerity measures, which leads to still deeper recession, which . . . well, you get the hang of it.

At the centre of this dilemma is Greece. Through reckless fiscal mismanagement over decades, Greece now has gross government debt of 160 per cent of its GDP (as against 24 per cent in Australia), and an annual interest bill equivalent to almost $100 billion here.

But it is also in an economic depression: its output has fallen by almost 20 per cent, 22 per cent of its workers are unemployed, and an appalling 54 per cent of its young jobseekers.

Which should it tackle first: getting its fiscal house in order, or trying to stimulate growth to provide jobs for its people?

That is what last Sunday's Greek election was about. But in a key complication, no bank will lend to Greece any more. Its only loan sources are the European Union, the European Central Bank and the International Monetary Fund, and (against the IMF's better judgment) they have insisted Greece meet the 2013 fiscal target. Given its economic free fall, that requires it to make another ?11 billion ($A14.2 billion) of spending cuts or revenue hikes: 5 per cent of GDP.

Greece's two main parties had joined forces to try to negotiate a better deal, but failed. The elections saw their combined vote plunge from 77 per cent at the previous election to 32 per cent this time, as voters flocked to parties to the left and right who reject the deal, yet have no realistic alternative. At this stage the elections seem to have left Greece at an impasse, with no viable government, and any new election likely to end in a similar impasse.

But the story has just taken a new twist. Merkel became the most powerful person in Europe, largely because the German public supported austerity, and the opposition Social Democrats had not opposed it until now. But on Sunday, in the Ruhr valley state of North Rhine Westphalia, Germany's biggest, her Christian Democrats were hammered in a state election fought on the issue of austerity, their vote falling to just 26 per cent.

Germany has not suffered the austerity seen in Greece, Spain or Ireland. But German voters objected to council swimming pools being closed as an economy measure. The west is weary of paying endless subsidies to east Germany. And Social Democrat Premier Hannelore Kraft won a personal vote that makes her a potential challenger to Merkel at 2013's federal election.

The trend in German state elections is startling. Since the last federal election, 10 of the 16 German states have gone to the polls: the Christian Democrats have won just two states while being dumped from office in four. They and their partner, the Free Democrats, have shrunk from 515 seats to 399, compared with 590 seats won by the Social Democrats and the Greens.

The crisis in Europe has now seen governments fall in 19 of the 27 EU members, including Britain, France, Italy, Spain and the Netherlands. Tonight Francois Hollande takes office as president of France, then flies to Berlin for dinner with Merkel. Hollande has been ambivalent about whether he wants to rewrite the EU fiscal pact, or just add a growth package to it, by increasing investment. Whatever his goal, he might find Merkel more receptive now.

But even if Hollande can reconcile the contradictions of his campaign promises to meet the deficit reduction targets while increasing spending, there is no good way out for Greece. No Greek government is likely to carry out the spending cuts the European Union requires. Too bad, says European Commission President Jose Manuel Barroso, we won't change the rules for you. And if the EU keeps its hard line, there will be a new financial crisis.

Greece would run out of money to pay public servants. It would have to exit the euro, default on its debts, and bring back a cheap drachma. Markets would speculate on defaults by other countries in strife: Spain, Portugal, Ireland. IMF chief Christine Lagarde warns that this could see a slump worse than the panic of 2008.

A crisis in Europe would convulse trade and financial markets. Australia's banks could face a crisis in rolling over loans. Our dollar would sink. Investments would be put on hold. All bets would be off.

Keep your eye on Europe.