Economic Overview

See it as another spring cleaning as yet another government is toppled (France) while others can’t get their act together (Greece) and may have another go at elections shortly (as early as June, along with Holland in September).

These are busy times as the European political landscape gets changed and recalibrated in line with electoral wishes after which the politicians do the reformatting.

The story so far is that Germany got the emphasis on fiscal prudence, budget cutting and severe doses of austerity that it wanted, to the point of peripheral and other electorates starting to push back.

Having probably achieved considerably more than perhaps originally hoped for, it may be time for a bit of common sense and water in the wine.

Instead of fiscal targets (expressed as percentage of GDP) in a deepening recession inviting deeper and deeper absolute cuts, it makes sense to set fiscal targets in absolute terms (billions) and allow some temporary fiscal easing as share of GDP as recession bites.

These were the sentiments of the IMF’s Lagarde this week as Francois Hollande swept into the French Presidency on a wave of anti-austerity (and anti-much else) and Greece was even more outspoken in its rejection of a fiscal corset that bites ever deeper with every additional notch of recessionary tightening.

Brussels appears to be readying for some time slippage in achieving the agreed fiscal targets this way, probably to be condoned by the finance ministers meeting in conclave, possibly as early as this week.

So there may be no change to the fiscal compact (a non-negotiable for Germany) but there could be some belated pragmatism about recognising the fiscal achievements to date, the impact of recession, and the electoral gauntlet being thrown down.

Besides, the German SDP opposition is in favour of it, and Mrs Merkel will need its approval, given that she needs a two-thirds majority to get the Eurozone fiscal compact agreed by the Bundestag, something that might not happen without the right emphasis, with Hollande now leading the charge on the European Left.

Then there is much talk about a beefed-up growth pact to accompany the fiscal compact, being a demand from France (but not only her), received with pragmatism by Germany.

Besides, it sounds good, being in favour of growth, and it may go down well with Mrs Merkel’s electorate in 2013.

It may not amount to much, however, to beef up the capital of the European Investment Bank with €10bn and guarantee a few hundred billion Euros of new European infrastructure investments, pro-rata shared and not new money, and this over a decade. In a regional economy with a GDP in excess of €10 trill, that’s small change.

Seeing the way the wind is blowing, the ECB has already been digging in, signaling it is not prepared for more easy money. Instead, pressure is being exerted on politicians to try harder to find the will to reform and improve Europe’s growth potential.

This is easier said than done, as especially populations, elites and politicians in many peripherals can’t always see the burning need for doing things very much differently (such as reforming supply sides).

For them their status quo structurally is often quite natural and acceptable. They define the problem mainly as one of insufficient demand. This largely explains their search for more demand spending, naturally debt-financed.

This reasoning doesn’t sit well with the Germanic tribes (or the ECB), which want more structural change, especially in peripheral labour markets to make industry more competitive and capable of supporting faster growth.

The bottom line is that change will probably come very slowly in Europe, keeping its growth very modest, and the structural pain (fiscal and unemployment) long and deep.

But there may be more progress here than meets the eye, especially in political terms.

For it was mainly the political right-of-centre that objected to more bailing out (known as creating a fiscal union). In contrast, many left leaning parties in all countries are more inclined to this next step in Eurozone integration.

With French President Hollande probably prepared to put his signature to a fiscal union immediately if asked to do so, and with Germany facing national elections in 2013 in which its political landscape may also change more decidedly, with Mrs Merkel possibly having to find herself a new alliance partner, the moment may be approaching where the idea of a fiscal union may gain greater momentum, with enlarged lifeboat guarantees, and European-wide bonds being issued to backstop some of the sovereign debt problems, taking pressure off the ECB.

They aren’t there yet, for Greece again looms large shortly. Greece has to find room to cut another 5% of GDP from its national budget by June, and frankly that’s not going to happen.

If Greece goes back to the polls, as is expected shortly, and the issue to be decided is greater austerity or bust, the country is likely to buckle. But if the key question is to decide whether to stay in the Euro or not, the protest vote against the two leading parties may soften, and they be given a majority in parliament (and the ability to form a government that will keep to the spirit of fiscal agreements, if not always to the letter).

The Greek elite apparently do not want to step out of the Euro, so getting this right is important for them.

Meanwhile, the cost and uncertainty of having to pay for the Greeks exiting the Euro is as much for Europe, if not worse, than simply guaranteeing some more of their debt and giving them some fiscal leeway in recognition of what has been accomplished (which not all see necessarily as overwhelming much) in order to keep them Euro-bound.

If Greece definitely decides politically that it is out, the cost of doing so will fall due, and left leaning opposition parties all over Europe may well demand a move towards greater fiscal solidarity (union) as the price for their agreement over the objections of large parts of right leaning electorates.

Why the wish to remain in the Euro? It is lonely out there, you know, all on your own, and completely ignored where it matters, a psychological aspect that applies to many central Europeans as well and not to be ignored.

If Greece can hold out, it and other European peripherals may find that over the next 18 months the political landscape may change enough to achieve greater Eurozone fiscal solidarity, ending the current sovereign debt impasse before mid-decade.

As things stand, outsiders no longer buy peripheral sovereign debt, this effectively being vacuumed up by domestic banks. ECB liquidity provisioning isn’t really ending up in the credit process (thus keeping growth short-circuited but also explaining why this bottled up liquidity isn’t an inflation danger – it is being used to shore up banks and governments mostly).

To get growth going, more will need to be done, some on the demand side, much more on the supply-side, with less expected from the ECB but more needed from a decisive breakthrough towards collectively guaranteed European bonds easing sovereign funding and terms (though keeping risk differentiation alive).

For this one needs fiscal austerity to have achieved its targets (getting there), governance rules to have been amended and agreed by parliaments (getting there), getting a greater emphasis going on structural reform in support of growth (under way in many peripherals, but resisted philosophically by French President Hollande) and finally agreeing to greater bailout lifeboats and bond guarantees (very much a slow coach but watch the evolving politics everywhere).

Thus the European crisis isn’t over, but it can be said to be inching politically towards the kind of agreements that limit austerity burdens without weakening their intent, agree on greater growth initiatives (without necessarily doing much or achieving higher potential growth) and make progress towards a common issuing of sovereign bonds greatly easing the financing plight and cost to all.

This process will not happen without repeated market pressures building up in coming months, creating just enough creative mayhem, along with the various electorates, to get the needed results pushed through.

Thus both electorates and markets pushing might conceivably get politicians acting enough to change the Eurozone architecture and lead in the right direction.

This in contrast to a scenario where one country decides to exit, market contagion takes over, the ECB capital base is called into question and the ensuing mess will take your breath away.

While for many in the watching audience this Doomsday scenario has its attractions, one should grant that most of Europe is quite capable, like America, to do the things that are right (for her) and act accordingly, compared to just let things blow up.

As to individual performances going forward, Spain has one of the fastest export growth records, Italy is a very wealthy country able to make adjustments, but admittedly Greece is the problem child, particularly her bloated public sector, where structural change will likely be slow and new sources of growth aren’t obvious.

But such doubts, also to a degree regarding Portugal, would also apply (if not worse) if it were to exit.

And so we wait to see these next 18 months, whether European elites, electorates, markets and the central bank have it in them to round all these square pegs.

Much has already been achieved, there is scope for pragmatism and flexibility alongside focused discipline required of all, and the outcome and its time table may well surprise, especially the hardened skeptics.