Athens to Madrid: back to you
Following the June 17 elections, Greece seems set to be governed by a broad, awkward coalition formed by the center-right New Democracy party, its historical rival, the center-left Pasok, and several small parties.
A consequence of this electoral outcome is that Greece is less likely to exit the eurozone within the next few months. On the other hand the new government will surely try to renegotiate the Memorandum of Understanding – the economic conditionality that sets the terms of Greece’s bailot – with the European Union.
Regardless of the new Greek government’s success in renegotiating the terms of the bailout, Greece will remain deeply mired in depression. Greece’s banking system is close to total paralysis, and is experiencing a depositor run. Lacking the ability to devalue its currency, the Greek economy remains deeply uncompetitive. Business and consumer confidence have collapsed. Multinational corporations and trade credit insurers are pulling out of the country at an accelerated pace.
The elections have not brought any meaningful change to Greece’s situation. So where is Europe’s crisis headed now?
Even as the crisis in Greece continues to escalate, global attention will zoom in squarely on Spain and Italy. And, possibly, increasingly on Germany, too.
Spain has seen its borrowing cost surge, with the yield on its 10-year sovereign bonds reaching 7.3% on June 18, and is on the brink of requiring a full-fledged international bailout. If Spain falls, it is hard to see how Italy could decouple from Spain.
Is the German economy headed for the doldrums?
Germany, of course, remains the single most important player in this crisis. But the way we perceive Germany – a strong economy, the paymaster of the eurozone – could evolve. One question that may arise in the wake of the intensification of economic, social and political tensions in Spain and Italy over the coming months is the following: will Germany itself be able to avoid a substantial economic slowdown?
The outlook on this front is far from reassuring. There are two main threats to Germany’s growth: the deepening Europe-wide recession and the cooling of emerging markets.
The downturn in struggling Eurozone countries seems to have begun to affect Germany. The German economy contracted by 0.2%, quarter on quarter, in the last quarter of 2011 relative to the third quarter. This contraction was driven by the sharp fall in exports to the eurozone. German GDP rebounded by 0.5%, quarter on quarter, in the first quarter of 2012, but the rebound was driven by exports to emerging markets, whose growth is now slowing.
These are worrying developments. Exports account for 50% of Germany’s GDP – versus 27% for France. Is the 7.5% contraction in manufacturing orders from eurozone companies in Q1 2012 a harbinger of the end of robust German growth?
Perhaps equally important, bad news for Germany could be compounded by developments outside Europe. There is much fear of the effects of a deep economic downturn in the eurozone on emerging economies such as China, but the effect of a marked deceleration of China’s growth on Germany could also be significant.
Eurozone exports represented 45% of Germany’s exports in 2003. By 2011, this figure had fallen to less than 40%. China and Asia account for over 6% and 15%, respectively, of Germany’s exports. If China’s GDP growth falls from its current 9.2% (2011) rate to 7.5% in 2012 – a cooling down that is expected by many economists – this would have a sizeable effect on global growth and affect both East Asian economies and – directly and indirectly – Germany.
A global slowdown
More broadly, the synchronized downturn that took place in 2008-2009 following the failure of Lehman Brothers seems to be staging a partial and modified repeat. This synchronized movement in growth across the globe underlines the importance of global linkages in shaping economic outcomes all over the world.
Indeed, following the sharp slowdown in Europe over the past year, growth in the United States and the United Kingdom is weakening, and now even emerging markets – which have fared well since 2009 – are cooling down.
What explains these synchronized downturns? Many factors are at play, but one of them is particularly important: we still live in a highly “coupled” world in which large economies’ business cycles move together.
Two of the most important linkages that keep the global economy tightly linked are global banks and global liquidity conditions. Large, global banks – most of them based in Europe – in particular play a crucial role in determining economic conditions in major economies.
Global liquidity can be defined as the ease of financing, which is shaped by both the public and private sectors. The public sector is made up mainly of central banks, while the private sector is composed of global and local banks, and capital markets. Private sector liquidity influences growth both directly and through trade.
Interbank lending, in particular, is a major source of private sector liquidity. The size and vast geographic reach of global banks means that there can be sizeable international spillovers from bank deleveraging, which mostly takes the form of a reduction of banks’ value-at-risk (a measure of potential losses) through the contraction of lending. When global banks deleverage and global liquidity conditions deteriorate, the global economy is likely to contract, with countries entering downturns in a relatively synchronized way. This is what happened in 2008-2009.
As Hyun-Song Shin and Valentina Bruno explain in a recent paper, “In a ﬁnancial system with interlocking claims and obligations, one party’s obligation is another party’s asset. When global banks apply more lenient conditions on local banks, the more lenient credit conditions are transmitted to the recipient economy.” The reverse is also true: when global banks apply stricter conditions on local banks, these credit conditions are then transmitted to the local economy, causing a big impact on growth.
But global liquidity also influences growth indirectly through trade. International trade complements international finance, since easier financial conditions spur growth in trade. Conversely, tight financial conditions constrain trade, for example by making it more difficult for firms to secure letters of credit. Uncertainty about the solvency of the bank providing the letter of credit can cause a further breakdown in confidence. This is exactly what has been happening in Greece recently. The growth of global supply chains in recent years magnifies the importance of these linkages between international trade and international finance.
What would be the impact of deteriorating German growth?
Assume that, as a result of the deepening eurozone recession and weakening export markets, German growth falls from 3% GDP growth in 2011 to, say, 0.5-1% growth in 2012. How will that impact Europe’s crisis? Two possibilities come to mind.
The first possible effect is a broad realignment of German politics.
Germany’s economy has performed exceptionally well since the onset of the crisis – in marked contrasted to the rest of the eurozone. Up until now, the German people have not directly felt the effects of the crisis. Growth has been relatively strong, and unemployment is near historic lows. This experience, of course, contrasts sharply with that of Southern Europeans, who have seen growth falter and unemployment soar.
A consequence of Germany’s exceptional economic performance and ability to weather the global financial crisis has been continued domestic political support for Angela Merkel. This support has arguably emboldened Merkel and given her a strong bargaining position in Europe’s crisis, allowing her to ardently defend a flawed narrative about the crisis and solutions to the crisis that have utterly failed. It can be argued, indeed, that Europe’s crisis is largely self-made, and that Merkel, along with ECB policymakers, bear great responsibility for bringing the eurozone to the brink of collapse.
Were Germany’s strong economic performance to end, Merkel could see her domestic popularity – and support for her party – plummet. In turn, this could cause major changes in Germany’s political landscape, notably by bringing back the center-left SPD into the ruling coalition – with decisive implications for Europe’s future.
It is not hard to imagine that the crisis solutions, policies, and institutions favored by a CDU-SDP grand coalition could be quite different from those favored by the current coalition.
This leads us to the second possible effect. In the wake of a severe downturn of its own economy, Germany’s cost-benefit analysis of the available options to get out of the crisis (namely, stay the course, or move much faster to deeper EU integration) could change.
Since the onset of the crisis, Germany has been extremely wary of the costs for its public finances of bailing out periphery eurozone countries. This wariness has arguably been the underlying reason for German leaders’ and citizens’ refusal to take steps (in particular much deeper and faster fiscal and financial integration through the creation of EU- or EZ-wide institutions) that many deem necessary to solve the crisis and avert the collapse of the eurozone.
If a sudden economic slowdown in Germany were to convince its people and its leaders that the cost of not doing what it takes to save the euro will ultimately dwarf the cost of doing what is needed to ensure the survival of the euro, it is possible – though far from certain – that Germany’s stance regarding crucial issues such as Eurobonds, the ECB’s mandate, and a banking union could veer from staunch opposition to support. Such a pivot would unlock the EU’s ability to evolve new and direly-needed institutions.
It is worth noting that these two effects are not mutually exclusive. Quite the contrary, they are mutually reinforcing.
The level of uncertainty about the future of the eurozone is unprecedented. The degree of economic and financial tension, both within the EU and globally, is enormous. Clearly, German domestic politics plays a critical role in determining the crisis’ dénouement. In the face of repeated, recursive eurozone policy failure on a massive scale, and with the euro on the edge of a catastrophic collapse, it would be paradoxical yet oddly fitting if the weakening of Germany’s economy provoked the tectonic political shift that saves the euro.
The article above is forthcoming in Global Policy.