Bill Jamieson: We may yet face a euro meltdown

THE fiscal crisis across Europe puts even America’s problems in the shade. We are truly ‘on the edge’, writes Bill Jamieson.

Never underestimate the capacity of the eurozone to upstage America when it comes to fiscal crisis. Barely had the graciously bipartisan post-result speeches been delivered than the fine words were lost in a torrent of commentary about the approaching US “fiscal cliff”.

But it is more likely to be the eurozone, not the United States, that will wobble on an even more precarious fiscal cliff in the coming weeks.

Over the past month troubling economic data has emerged from the single currency area. As if following the well-rehearsed practice of picking a good day to bury bad news, the European Commission let slip yesterday, while all eyes were turned to America, sharply downgraded forecasts for the EU and the eurozone. These figures had a bigger negative effect on markets than the pressing problems of America’s budget deficit post the Obama triumph.

The eurozone crisis displays every sign of being about to re-erupt. Figures from both eurozone member countries and from Brussels-based Eurostat suggest major trouble ahead. Unemployment across the single currency area has risen to a new high of 11.6 per cent, while inflation pressures remain persistent. With external devaluation denied, internal devaluation is reaping a whirlwind of weakening economic activity and falling wages across the vulnerable economies. In Spain, now with an unemployment rate of almost 26 per cent, this looks a truly toxic combination.

The stronger the downward pressure of recession, the more difficult it is for governments to reduce their debt burden. The debt to GDP ratio of the currency union has now reached 90 per cent – and there is no sign this is going to be reduced any time soon.

Little wonder that in countries such as Greece, Italy, Portugal and Spain there is a deepening apprehension over escape hatches being closed and walls closing in. A full bail-out for Spain and perhaps another for Italy are looming on the horizon, while Greece continues to be paralysed by 48-hour general strikes in protest at a proposed new wave of austerity.

Just a few months ago it seemed as if the black clouds of the euro crisis had been dispelled with the pledge by Mario Draghi, the European Central Bank president, to do “whatever it takes” to avoid sovereign default and a euro currency meltdown. Now the black clouds are gathering again as Mr Draghi’s bluff looks set to be called.

The ECB is under growing pressure to activate its bond-purchase plan – Outright Monetary Transactions (OMT) – to help Spanish, Greek and Italian governments. The fear is that market confidence in the OMT programme is ebbing. Spanish government yields are edging back up from the “lows” reached in the immediate aftermath of Mr Draghi’s original announcement.

However, according to the rules that Mr Draghi attached to the OMT offer – that governments had first to make a formal request for financial assistance under the plan – there are no government bonds he is allowed to buy because no formal request has been received. ECB officials have made clear that neither the Irish nor the Portuguese qualified for the OMT because they did not have full market access. The ECB, with a deeply apprehensive Germany breathing down its neck, is in no mood to play Lady Bountiful.

The focus has returned to Greece and in particular whether more bail-out money could be disbursed. But it seems the German government is unhappy with the recent drift of events. How long can Greece keep going without more funds? While the Greek government had earlier said it would run out of money on 16 November, there is now a general assumption that it would be able to keep going, if necessary, until early December. Fingers are crossed that this is so, and that events in Portugal and Spain do not provoke a more immediate test of Mr Draghi’s rescue fund conditions. But it would not do to count on it.

None of this is to minimise the potential for a global economic jolt from America’s “fiscal cliff”: the $600 billion (£375bn) of tax rises and spending cuts due to hit the economy in January. The fear is that this combination could sabotage a nascent US economic recovery and could even push the US back into recession. The prospect of the US Federal Reserve having to continue with its programme of quantitative easing was the main reason why the dollar weakened yesterday.

How steep is the cliff? According to the Congressional Budget Office this summer, failure to change course would result in a gross reduction in the budget deficit in 2012-13 of $607bn. By far the larger part would result from tax rises. The expiry of the so-called “Bush tax cuts” on 31 December would account for $221bn of the total and the lapsing of the payroll tax rebate for $95bn. Thus, almost two-thirds of the forecast cut in the budget deficit would come from mandated tax increases. Only $65bn of the projected reduction would result from spending cuts. The payroll tax rebate, were it rescinded, would not really represent a tax hike. But as economist Stephen Lewis of Monument Securities notes, “the ‘Bush tax cuts’ have been enjoyed for a long time – long enough to have become embedded in the planning of taxpayers”. The Republicans will feel bound to oppose their repeal.

Can President Obama secure a deal? The Republicans claim their success in the House of Representatives’ elections gives them a mandate to resist tax increases as a means of reducing the deficit. Much will come to depend on the underlying resilience of the US economy. The continuing pile-up of US debt is widely seen as a threat to global financial stability, while a double whammy of tax rises and spending cuts could wreck growth. An underlying growth rate of two per cent suggests little room for any tax increases or spending cuts.

It will be a cliffhanger, but a deal still looks the more likely outcome. The hope for now is that monetary policy continues to work to boost the flow of bank lending to business and consumers. Energy is cheaper – $20 a barrel less than in Europe. And there is America’s entrepreneurial ability to gain huge advantage from the online economy.

Meanwhile, the bigger problems for us remain the inability – or unwillingness – of the eurozone to cope with the fiscal cliffs of its own, and the highly precarious state position of those economies now truly “on the edge”.