Last updated: December 21, 2014 6:14 pm
In the next act of the eurozone’s economic drama, keep a close eye on Spain
Deflation need not be the end of the world if it is the result of structural changes that boost optimism, writes Stephanie Flanders
The eurozone has been in limbo in 2014: no longer in the depths of crisis but not yet firmly on the road to the recovery. Many investors fear 2015 will offer more of the same — more hesitant growth, more concern at the prospect of deflation. But it could also be when we find out, one way or another, whether the current strategy for fixing the eurozone is workable — not just economically but politically.
Supporters of the current approach once pointed to Ireland as their model pupil. It has grown by about 5 per cent in 2014 and could do the same in 2015. But Spain is a more reasonable example, and in many ways an encouraging one.
In cash terms, only the US borrowed more from the rest of the world than Spain in 2006. The Spanish current account deficit that year was 9 per cent of gross domestic product, more than twice as high as Ireland’s
Put another way, Spain went into the crisis with more than its share of imbalances, and its government has since done as much as could reasonably be expected in any democracy to fix them.
Crucially, the economy is starting to register some reward for all this pain. While the recovery stalled in large parts of the eurozone from the spring onwards, Spain’s economy has expanded at an annual rate of 2 per cent since the first quarter. Recent surveys show some loss of momentum but it still expected to be the fastest growing of the big eurozone economies in 2015.
German policy makers would note that this progress has come despite falling prices. Spain is set to be the only big European economy to record a negative average inflation rate in 2014. Yet business investment and employment have been growing since 2013, in contrast to Italy and France, where both continue to decline. So one moral of the Spain story is that deflation does not have to be the end of the world if it is the result of structural changes that make businesses more optimistic about growth.
But there are wrinkles in this encouraging tale. The first is fiscal. Though the government did undertake heroic austerity measures in the thick of the crisis, it has recently put the belt-tightening on hold. The underlying budget deficit in 2014 will not be very different from that of 2013, and the draft budget going through parliament suggests a similar number for 2015. Gross public debt is 100 per cent of GDP and still rising. It is set to fall only from 2017 — and then only on the assumption that inflation rises steadily from now on. Spanish politicians say even the current budget plans may prove too demanding, with regional elections due in May and a general election within the next year.
Mr Draghi might say Spain’s faster growth rate showed the importance of using fiscal room for manoeuvre to ease the path through structural reforms. Others would say it shows the political costs of squeezing the economy and the budget so hard in the aftermath of the crisis.
Policy makers want to believe this muddle-through combination will be enough. Even in an environment of near zero inflation, they hope the eurozone and its battered governments are on a path that is both financially and politically sustainable. There will be no better test than the next 12 months in Spain.
The writer is chief market strategist for UK and Europe at JPMorgan Asset Management
As usual, the starring roles in the drama will be played by Angela Merkel , German chancellor, and Mario Draghi, president of the European Central Bank. But if you really want to know how things will turn out you should also keep a close eye on Spain. If that country cannot make the current mix of structural reform and loose monetary policy work, it is difficult to see how it will be sustainable for the single currency as a whole.
Supporters of the current approach once pointed to Ireland as their model pupil. It has grown by about 5 per cent in 2014 and could do the same in 2015. But Spain is a more reasonable example, and in many ways an encouraging one.
In cash terms, only the US borrowed more from the rest of the world than Spain in 2006. The Spanish current account deficit that year was 9 per cent of gross domestic product, more than twice as high as Ireland’s
In the post-crisis years a wrenching process of squeezing domestic demand and employment has helped turn that trade gap into a modest surplus. The Spanish banking system has gone through its own costly restructuring and the underlying budget deficit has come down from 10 per cent of GDP in 2009 to less than 5 per cent. Spaniards have paid a heavy price for all that adjustment: real incomes have fallen 5 per cent since 2008 and the country is plagued with record unemployment.
Crucially, the economy is starting to register some reward for all this pain. While the recovery stalled in large parts of the eurozone from the spring onwards, Spain’s economy has expanded at an annual rate of 2 per cent since the first quarter. Recent surveys show some loss of momentum but it still expected to be the fastest growing of the big eurozone economies in 2015.
German policy makers would note that this progress has come despite falling prices. Spain is set to be the only big European economy to record a negative average inflation rate in 2014. Yet business investment and employment have been growing since 2013, in contrast to Italy and France, where both continue to decline. So one moral of the Spain story is that deflation does not have to be the end of the world if it is the result of structural changes that make businesses more optimistic about growth.
But there are wrinkles in this encouraging tale. The first is fiscal. Though the government did undertake heroic austerity measures in the thick of the crisis, it has recently put the belt-tightening on hold. The underlying budget deficit in 2014 will not be very different from that of 2013, and the draft budget going through parliament suggests a similar number for 2015. Gross public debt is 100 per cent of GDP and still rising. It is set to fall only from 2017 — and then only on the assumption that inflation rises steadily from now on. Spanish politicians say even the current budget plans may prove too demanding, with regional elections due in May and a general election within the next year.
That brings us to the second and most dramatic wrinkle in the story: politics. At the start of 2014, the radical leftwing party, Podemos, did not exist. Today it is the most popular political movement in Spain.
Everyone looks at the country’s experience and sees a confirmation of their point of view. The reality is we do not know how things will turn out. But that is equally true of the eurozone as a whole. And, while gloom about the single currency has been firmly embedded in the financial markets for some time, there might now be scope for investor optimism. Positive forces will be acting to support the economy next year that were absent in 2014, including cheaper fuel, a more competitive exchange rate and a more proactive ECB.
The writer is chief market strategist for UK and Europe at JPMorgan Asset Management
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