European Union: Bumper Euro Edition, Syriza & Quantitative Easing Assessed

Last Updated: 3 February 2015
Article by Ian Stewart

Most Read Contributor in UK, August 2017

Syriza's victory in Greece's General Election has understandably stoked fears of a Greek exit from the single currency. This week we explain why we think Greece is most likely to stay in the single currency. It's been a busy week in the euro area with the European Central Bank launching a programme of full blown Quantitative Easing on Thursday. We also briefly assess whether Quantitative Easing could mark a turning point for the euro area economy.

Despite all the media talk of a Greek exit from the euro area, Syriza is a pro-euro party. True, it wants to re-write the rules for membership, casting off the austerity imposed by Greece's international creditors, but it wants to stay in the euro area. This policy of having your cake and eating it has electoral appeal. Yesterday's vote was against austerity, but those who voted overwhelmingly want to stay in the single currency. In a recent poll, 75% of Greeks polled said that Greece should remain in the euro "at all costs".

Germany has indicated that it won't change the rules for Greece and that it is willing to contemplate a Greek exit from the single currency.

As Chancellor Merkel's chief advisor, Michael Fuchs, recently put it: "If Alexis Tsipiras [Syriza's leader] thinks he can cut back the reform efforts and austerity measures, then the troika will have to cut back the credits for Greece...The times where we had to rescue Greece are over...Greece is no longer of systematic importance for the euro."

In our view Germany and Greece have a mutual interest in keeping Greece in the euro. Our guess is that, in the end, Germany and the other euro area countries will make marginal concessions which will keep Greece in the single currency.

To understand the choices facing Greece and Germany we need to understand the extraordinary scale of the adjustment in the Greek economy in the last five years.

Greece received bailouts from its international creditors, in 2010 and in 2012. In return for writing off part of Greece's public debt and giving it longer to pay the balance, Greece has cut public spending, liberalised and de-regulated its economy and sought to boost the efficiency of the public sector.

Since the first bail-out in 2010, Greece has endured the most severe contraction of any advanced country since America in the Great Depression. Greece's economy has shrunk by about 25% and unemployment reached a peak of 28%. This is a staggering economic shock. But in terms of what it was intended to do, the shock is working.

Greek public expenditure has fallen by 30% in the last five years. (In supposedly austerity-stricken Britain public spending rose 9% over the same period). Since 2009, Greece has shrunk its public sector deficit far faster than any other industrialised economy. The IMF estimates that this year Greece's budget, excluding the effects of the economic cycle, will show a surplus equivalent to 1.6% of GDP, a stronger underlying budget position than any other Western nation, including Germany.

Greece has also made progress in boosting competitiveness. Lower wages, which have fallen by about around 18% from their peak, have put terrible pressure on households, but have also made Greece more competitive. Greek consumer prices have dropped by 2.6% in the last year; coupled with a sharply lower euro this increases the attractiveness of Greek products and services to overseas buyers.

As Syriza's victory demonstrates, the economic situation is still bleak. Greece is carrying a crippling burden of accumulated government debt, equivalent to 166% of GDP, twice the UK's or US' levels. Living standards have plummeted. One in four people who want to work are unable to find a job.

The situation is very difficult, but things are moving in the right direction. The major cuts in public spending have happened. In terms of growth the worst is past. The economy is growing and economists expect Greece to expand by 1.8% this year, putting it towards the top of the euro area league table.

So where does this leave the new government in Athens?

It needs to keep Greece in the euro and to extract something from its European partners that it can represent as a victory at home. Staying in the euro area is what Greeks want and it offers the least risky path to growth over the next couple of years. Syriza has come to power at the right stage in the economic cycle. Growth is edging up and the massive fiscal squeeze is drawing to an end. Exiting the euro would be fraught with uncertainty and would stop the inflows of EU funds (equivalent to 2.9% of Greek GDP in 2013). Outside the euro, the Greek government and private institutions would face the risk of not being able to borrow overseas.

Syriza can legitimately argue that Greece has made large strides to meet its fiscal promises and may well extract some sort of symbolic concessions. We think it most unlikely that Syriza will succeed in persuading Germany and others to write off Greek government debt. A face-saving alternative for Syriza could come in the form of an agreement to give Greece longer to pay its debts coupled, perhaps, with some marginal easing of fiscal policy (in fact the European Commission and the IMF already assume that there will be some easing of budgetary pressure this year).

The euro area seems less at risk from a Greek exit now than in 2011-12. That crisis was brought to an end by the launch of the European Central Bank's so called Outright Monetary Transactions (OMT) programme. OMT allows the ECB to buy the government debt of at-risk countries without limit. It has helped rebuild market confidence in the ability of the euro area to stick together. Despite the growing risk of Greek exit, financial markets are working on the assumption that the ECB would step in to support other indebted nations, such as Italy or Spain. So far the ECB seems to have limited the risk of contagion from Greece to the rest of the euro area.

A Greek exit would doubtless be made easier by the planning and thought that will surely have taken place since 2011-12. Some even see advantages in a Greek exit in that it would reinforce the pressure on other indebted nations to stick to the rules.

Yet letting go of Greece would be a huge risk for the rest of the euro area. A Greek exit would probably see Greece defaulting on the €256bn of debt that it currently owes its European creditors. Germany holds €72bn of this debt but weaker European nations also have significant exposure, with Italy holding €48bn and Spain €33bn. A Greek default would exacerbate the problems for such countries and might force them to seek further assistance from the ECB. No one can be sure that markets would regard Greece's departure as a complete one-off or what the knock on effects on financial markets might be. In short Greek secession is the last thing the euro area needs as it grapples with deflation and low growth.   

A Greek exit may cause less collateral damage than in 2011-12, but huge and imponderable risks remain for both sides. Ultimately we think these risks are most likely to lead to some sort of compromise. We would put the probability of Greece staying in the single currency for at least the next two years at 75%. That leaves a non-trivial risk of exit, one which, until it is significantly reduced, is likely to weigh on sentiment in, and about, the euro area.

The other big news in Europe over the last seven days has been the ECB's announcement of a programme of Quantitative Easing (QE).

The ECB's response to low growth and the threat of falling consumer prices in Europe is a six-fold increase in its monthly asset purchases and, crucially, the buying of government debt for the first time. This is an ambitious programme far exceeding market expectations in both scale and duration. Although the programme is scheduled to last from March this year to September 2016 the announcement leaves open the possibility that it could be open ended.

The supporters of QE hope that it will raise asset prices, increase liquidity and drive down the cost of credit. The aim is to stoke risk appetite and fuel spending and investment.

Some effects are already visible. Yields on 10-year bonds issued by eight euro area countries, including Germany, France, Italy and Spain, hit record lows after Thursday's announcement. The euro hit a new 11-year low against the dollar and European equities have rallied. We suggest keeping an eye out for survey data over the next month to assess if this optimism has fed through to European businesses and consumers. (The key German IFO confidence survey, out later this morning, is likely to show that business confidence has risen for the third consecutive quarter).

Some critics argue that Europe's woes are due to weak demand, which, they believe, could be far more effectively addressed by increased government spending and tax cuts. Others point to weak competitiveness in highly-indebted peripheral European economies as the root cause of the problem.          

QE is not a panacea for Europe's afflictions. It won't drive structural reform and it won't do anything to encourage Germany to increase public spending to try to boost demand. QE is not a perfect weapon, but it is the one that the ECB has to hand. In the US and UK QE is widely – though not universally - believed to have significantly raised growth and inflation.

On balance we are QE optimists. QE is being launched in the euro area at a time when credit demand among consumers and corporates is, perhaps surprisingly, heading up. Euro area consumer confidence is at above-average levels. Our hunch is that a potent combination of rising real incomes and cheap money should ensure that the euro area posts slightly better growth this year than last.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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