EKIP– Expert Club for Economics and Politics A Different Opinion
With the deepening of the debt problems in the Eurozone in 2008 and the subsequent entry into recession, promises at the parliamentary level began to multiply, ambitions sharpened, and the path to growth seemed so clearly outlined that ... five years later, it is hard to believe how far we actually are from the dreamed-of recovery.
Global economic crisis! This phenomenon has been used so often as an excuse by the political elite lately that it even intuitively emerges as a response to the troubles in the Eurozone[1]. However, the data are categorical. The aggregate trade balance (goods and services) of the Eurozone reached a record high surplus of 102.2 billion euros in the first quarter of 2013, which represents an increase of 26.9% year-on-year. In fact, a negative trade balance was not recorded even during the recession that began in late 2008. Moreover, the balance of payments also recorded consecutive surpluses, with the balance effectively doubling to 167.0 billion euros in 2012. Therefore, a possible underestimation of external demand cannot be the primary source of the anaemic growth in the Eurozone in recent years, since the net balance with non-residents is actually positive and growing at an accelerating pace. Europe exports.
The essence of the Eurozone's headaches...
The problems are deeply rooted within the economies themselves. If we look at the data on real GDP, calculated using the expenditure approach, we will see that for the period Q1 2008 – Q1 2013 the trade balance contributed as much as 2.5 percentage points to the growth of the Eurozone economy (Chart 1). The government sector also managed to have a positive effect, which in turn calls into question the rising dissatisfaction with the “extremely strict” requirements for the expenditure side of state budgets. In fact, the factor that exerts negative pressure on economies is precisely private demand. Household consumption remains below the peaks of 2008, contributing 1.2% to the decline in GDP over the past five years. However, the negative pressure coming from investments is much stronger. Gross capital formation fell by as much as 21.2% for the period. The result is extremely disappointing - the size of the Eurozone economy in the first quarter of 2013 remained a full 3.3% below its peak in early 2008.
Chart 1. Change in real GDP for the period 2008-2013 and contribution to growth
Source: Eurostat, author's calculations
While countries like Germany and Austria have managed to emerge from the recession, the state of the so-called “pig” economies[1] is in a much more deplorable state. Unemployment in Spain remained at a record high of 26.4% in the second quarter of 2013[2], and the government still has no answer to the accumulating budget deficit, which reached almost 4.0% of GDP in June[3]. Greece’s real GDP has not grown since 2008, and in the first three months of 2013 it fell by 5.6% on an annual basis. Portugal and Ireland, for their part, are still far from regular participants in the long-term government bond market.
Even the largest economy in this group (Italy) is mired in political crisis and suffers from a lack of growth. The spread between Italy’s 10-year government bonds and their German counterparts is currently 260 basis points[4] and is likely to widen given the country’s credit rating downgraded by 1 notch to BBB (S&P) due to the deteriorating economic outlook. Moreover, the debt problems of the PIIGS countries are not only not easing, but are actually intensifying. The ratio of these countries’ gross government debt to GDP reached an average of 127.2% in the first three months of 2013, or a full 14.9 percentage points higher than a year earlier[5].
So why are investment and private consumption floundering?
It is not surprising that the reason lies in the banking sector. European economies have adopted a model in which a significant part of investment and consumption is financed through borrowed funds. In other words, in order to maintain the growth of private consumption and gross capital formation, commercial banks need to ensure a continuous inflow of monetary resources. This is exactly what happened at the beginning of the century, when European economies were in their prime. But in the current conditions of stagnation and low prospects for the leading economies in the Eurozone, an extremely unfavorable environment has been created for granting new loans to the private sector, especially in the case of small and medium-sized businesses. The presence of an excess supply of borrowed funds on the eve of the recession in 2008. (Chart 2) managed to stabilize quickly, after which the rate of change in lending and real growth of the economies in the Eurozone began to move within narrow limits over the past few years, giving a negative indication of development in the medium term.
Chart 2. Change in real GDP and private sector lending in the Eurozone, %
Source: ECB
Another and equally significant problem is the financial condition of the banks themselves. In the years before the crisis, financial institutions fiercely attacked any opportunity to buy up then-popular, but now more notoriously toxic assets. And while banks in the US were instantly capitalized during the financial crash, in the EU events converged in a different way, which seemed to turn the banking sector’s problems into chronic ones. The price-to-book ratio[6] for European banks currently remains below one on average, which practically means that investors find banks more valuable dead than alive[7]. If we delve into the recent past, we will easily make an association with the 1990s in Japan, when banks were neither stable enough to lend nor in a bad enough state to fail.
Interestingly, it was precisely the weakened lending that was targeted by the ECB through record quantitative easing. The question is where did this money go. Banks as financial institutions do not make exceptions and their main goal is to register a positive financial result, i.e. profit. It is quite logical that when loans become a risky instrument rather than a main source of income, banks should look for alternatives, and government securities of Eurozone countries turned out to be a great option. As a result, the value of securities other than shares on the balance sheet of commercial banks within the Eurozone swelled by 58.6% for the period August 2008 - May 2013, which in absolute terms amounts to 876.5 billion euros. And if for some this increase is not significant, we must note that it is realized in a period of record high budget deficits and indebtedness of the member states. The situation is no different in the capital markets, where the main market indices in Germany and the UK reached historic highs in May 2013 in conditions of extremely meager economic growth.
Chart 3. Value of securities other than shares on the balance sheet of commercial banks within the Eurozone (billion euros)
Source: ECB
The bottom line
After five years of heavy intervention by both the public sector and the ECB, record low interest rates and alarmingly rising deficits, the Eurozone has once again recorded three consecutive quarters of economic decline and has technically entered recession again. In early July, the IMF revised its growth forecast for the currency union downwards, with the new forecast predicting a contraction of 0.6% in 2013 before GDP grows only marginally by 0.9% in 2014. Clearly, the current model of the banking system is not delivering the desired results, and the headlong rush towards a full banking union sharply increases the number of question marks in the equation. For now, however, one thing is certain - until the business environment improves to provide carte blanche for lending, the dreamed-of growth within the Eurozone will remain somewhere in the unforeseeable future.
