Michael Wohlgemuth: Why the EU cannot bank on Germany’s economy

Open Europe Berlin Director Michael Wohlgemuth has written an interesting piece for World Review, looking at the current status of the German economy. Here it is:

The German economy is showing clear signs of weakening. GDP declined by 0.2 per cent in the second quarter of 2014 and German business sentiment fell for a fifth straight month in September to its lowest level in 17 months. Manufacturing orders dropped during August to the lowest level since May 2013.

Germany’s problems will remain and get worse.

Much of the resilience of the German economy during the last years can be attributed to harsh labour market and social security reforms. These were introduced by the Social Democrat Chancellor Gerhard Schroder (1998-2005) in 2003 with his ‘Agenda 2010’.

The new centre-right / centre-left coalition led by Chancellor Angela Merkel has rolled back many of these reforms by reintroducing early retirement, granting extra pensions for mothers and installing an unprecedented legal minimum wage - of 8.50 euros per hour - in all sectors and all regions of Germany.

The German government has been forced to admit that the minimum wage will increase labour costs by 10 billion euros. It is still unclear how many jobs will be lost after its introduction in 2015.

The new pension benefits will cost around 200 billion euros until 2030. Early retirement could take up to 250,000 elderly off the job market over the coming years when skilled and experienced labour is becoming increasingly scarce and valuable.

Demographic decline will be Germany’s greatest challenge in the long run: coming decades could see Germany’s workforce shrink by about 200,000 every year. The old age dependency ratio - between those older than 65 and those of working age - could increase from 31 per cent in 2013 to 57 per cent in 2045.

Immigration to boost the workforce would be essential. Experts calculate that net-migration of around 400,000 people a year - preferably young and educated - would be needed to avoid demographic decline.

So where should Germany’s future economic growth, desperately needed to pay for pensions and somehow to rescue the eurozone, come from?

The answer is from productivity and innovation, in short: smart investment. Labour participation rates, labour productivity and entrepreneurial ingenuity would have to increase dramatically.

However, Germany’s productivity growth is lagging behind almost all other economies in the world.

The established German Mittelstand - its economic backbone of small and medium-sized enterprises - and some big exporting firms, are still good at innovation. However, Germany holds a dismal 111th place in the World Bank’s ranking for ‘ease of starting a business’ and its service sector is under-developed and over-regulated, while Germany’s education system fails to produce enough matching skills.

Germany’s capital stock is depreciating faster than new investments are replacing it. A declining capital stock combined with a declining workforce, leaves no hope for a growing economy.

That does not mean Germany’s government must add more public debt to the mix.

Many observers are demanding that the government abandons its ‘austerity obsession’ and take advantage of the historically low interest rates for more debt-financed ‘stimulus’.

But the Merkel government is still in the position to do the right thing and increase investment without abandoning the new constitutional balanced budget rule. German politics should also provide better regulatory and tax environments for private domestic investment and lower barriers to entry for its service sector.

Domestic industrial investment is also increasingly discouraged by the ‘lonely revolution’ to wean Germany off both fossil and nuclear energy.

This policy may cost consumers, taxpayers and business up to one trillion euros over the next two decades, according to Peter Altmaier, the former minister for the environment, who is now chief of the Chancellery and minister for special affairs.

German energy costs are now more than double those in the US, while Germany’s greenhouse emissions have increased.

German entrepreneurs and foreign investors have always had these negative factors on their radar.

Germany’s problem is not austerity, but demography and complacency. The message is you cannot bank on Germany.

What’s wrong with Finland? Part 2

Since our last post on this issue things seem to have only got worse for Finland.

The European Commission’s latest economic forecast (see table below, click to enlarge) made pretty dire reading with Finland expected to be one of the worst performers in terms of economic growth over the next two years.

Furthermore, it seems that the credit rating agency S&P has finally caught up with our analysis of Finland, putting its AAA rating on negative outlook, suggesting that it may lose it in the next couple of years. Similar to our concerns about the rebalancing of the Finnish economy, the demographic problems and a stubborn lack of competitiveness, S&P noted:

“Finland’s persistent subpar growth rate reflects deep structural demographic and economic imbalances that hamper the government’s efforts to achieve fiscal consolidation. We consider that there are downside risks to growth and policy implementation.”

“We believe that the economy remains vulnerable to any slowdown of economic activity in the euro area or among other major trading partners, such as Russia.”

As the second part of the quote suggests, the situation in Ukraine and the potential sanctions on Russia are also likely to worsen the outlook for Finland.

The graphs above (data from Bank of Finland) highlight that Russia accounts for a decent chunk of Finnish trade and given the dwindling sources of growth any hit to this could certainly hamper the rebalancing of the economy and the reform/recovery process.

Furthermore, as we have flagged up before, Finland is one of the many countries heavily reliant on Russia for gas and energy more generally. With Putin’s threat to cut off gas to Ukraine the situation has potentially escalated another step, at least in economic terms, Finland is one (of the many countries, including Russia) which is on the front line.

Once again, all this is not to say that Finland is an economic basket case, far from it, but that even the healthy economies in Europe are undergoing some serious overhauls and reforms, further complicating the crisis response and, now, dealing with issues such as the Ukraine-Russia crisis.

What’s wrong with Finland?

That seems a strange question to ask. The country is a paid-up member of the eurozone core and is one of the few countries in the world to have a triple A credit rating from all three top agencies (S&P, Moody's & Fitch) and a stable outlook from all.

However, as the chart to the left shows (taken from the most recent Finnish Central Bank Macroeconomic bulletin) and today’s GDP data confirm (the Finnish economy contracted by 0.8% in Q4 2013) suggests all might not be well.

GDP growth has stagnated and is now teetering on the edge of slipping into its third recession in six years. But what has been causing this? The chart below on the right provides some insight.

The first point to note is the collapse in the electrical and electronics industry. This has been largely down to the struggles of Nokia. Formerly a dominant player in the telecoms market the firm has failed to adapt to the changing nature of the market, in particular the smart phone phenomenon, and has seen its market share, profits and share value eroded. The sector has also suffered knock on effects of the reduced global demand in the wake of the financial crisis, the threat of low cost emerging markets and the struggling domestic demand due to falling confidence.

Similarly the large metals industry has also been hit by the global downturn and has struggled with price competitiveness. In particular the ship building industry would have been doubly hit by the struggles in global trade and is yet to truly recover.

It was previously said that Finland lived off its forests. This is no longer true, or at least it is no longer able to fully. The forest industry and the related wood, textiles and paper industry have struggled with changing technologies. Demand for paper and related products has fallen substantially as digital replacements grow and environmental concerns take hold. Again cheap emerging market products may also threaten in this area.

The combination of all this has been falling employment and an accompanied fall in domestic demand, keeping downward pressure on the economy. At the same time Finland is also beginning to run into the same demographic problem facing much of the developed world – the decline of the working age population and the increase in the number of dependants.

It’s clear that Finland remains a very strong and healthy economy. However, it is clearly undergoing some serious structural changes and may continue to post low growth figures for some time to come. Fortunately, public debt remains low at around 59% of GDP, while the deficit continues to be under control at 2.4% of GDP, and unemployment remains at just 8.1% despite recent increases. This should give the country plenty of space to conduct the structural changes needed.

That said, the case of Finland provides further evidence (as we have pointed out for Germany) that the peripheral eurozone countries aren’t the only ones undergoing significant changes.

Eurozone private sector growth beats expectations, but hides divergence

This morning saw the release of the latest set of Markit Purchasing Managers’ Index (PMI) - a set of indicators used to measure the economic health of the manufacturing and service sectors. The figures for the eurozone as a whole once again beat expectations.

Eurozone Composite PMI (Aug A) M/M 51.7 vs. Exp. 50.9 (Prev. 50.5)
Eurozone Services PMI (Aug A) M/M 51.0 vs. Exp. 50.2 (Prev. 49.8)
Eurozone Manufacturing PMI (Aug A) M/M 51.3 vs. Exp. 50.8 (Prev. 50.3)

German Flash Composite PMI (Aug A) M/M 53.4 (Prev. 52.8)
German Services PMI (Aug) M/M 52.4 vs. Exp. 51.8 (Prev. 51.3)
German Flash Manufacturing PMI (Aug A) M/M 52.0 vs. Exp. 51.2 (Prev. 50.7)

French Composite PMI (Aug) M/M 47.9 (Prev. 49.1)
French Services PMI (Aug) M/M 47.7 vs. Exp. 49.2 (Prev. 48.6)
French Manufacturing PMI (Aug P) M/M 49.7 vs. Exp. 50.2 (Prev. 49.7)

We covered this issue in detail last month and, needless to say, our thoughts haven’t changed much in such a short space of time, but there are a couple of points to note.

• Again, this is another small positive piece of data for the eurozone, in particular the eurozone services PMI is at its highest point for 2 years while the manufacturing at its highest since June 2011.

• That said, the on-going problem of divergence (which we have discussed before) continues to loom large. As Germany continues to post strong economic data, France looks to be showing signs of struggling, despite its unexpectedly positive GDP growth in the second quarter of this year. This divergence has the potential to become a serious problem for both the ECB (in terms of trying to balance its monetary policy) but also for the Franco-German axis which has long been at the core of the eurozone and vital to its stability.
• This turnaround in economic data for the eurozone has unfortunately coincided with problems/issues elsewhere in the global economy. The Chinese economy (a big source of trade for the eurozone) has shown signs of stumbling, while the US Fed is toying with the prospect of tightening its monetary policy - this could impact global liquidity and sentiment with suitably negative knock-on effects for the eurozone. With Germany leading the way as an export orientated country and many in the periphery  looking to copy this (through choice or Troika programme), the eurozone continues to be reliant on external demand.
• The combination of positive economic data and long term forecasts of loose ECB policy are helping boost sentiment in the eurozone more broadly. However, some significant questions are looming, notably how to fund the likes of Greece, Portugal and Ireland as their bailout funding winds down over the next year. These issues have so far been pushed into the long grass but the time is quickly approaching where answers are needed, unfortunately indicators here are much less positive than the PMIs. More ad-hoc structures seem to be the likely outcome.

German growth leads the eurozone out of recession but can it really lead the eurozone out of its crisis?

As has been widely covered today, the eurozone exited recession in the second quarter of this year, growing by 0.3% (over expectations of 0.2%).

We posted our thoughts on this expected ‘turnaround’ in the eurozone a couple of weeks ago, so we won’t rehash them. Needless to say the figures are a positive but there is still plenty of negative data around (unemployment, bank lending to real economy, consumer confidence), so European leaders should refrain from getting overexcited.

The key point for us remains this issue of divergence. It’s worth noting that Germany and France played a significant role in pulling the eurozone average growth up. There also seems to be a prevailing logic that German growth can play a big role in pulling the eurozone out of its crisis. As we have noted before we’re fairly sceptical of this idea for a couple of reasons.

There are two mechanisms through which German growth could in theory help boost struggling eurozone countries:

• Firstly by boosting German demand for imports from these countries significantly.
• Secondly by moving Germany away from its export model (possibly through decreased competiveness) allow these countries to fill that gap and export more.

1. Boosting imports
 

(Data up to end of 2012, however imports from eurozone countries have continued to decline in 2013)

As we have discussed before, and as the graph above shows (click to enlarge), German imports from peripheral eurozone countries have decreased substantially with only Italy featuring as one of Germany’s top ten trading partners. Furthermore, imports from other EU countries have declined to 56% of total imports – with the eurozone accounting for approximately 38% of this and peripheral eurozone states a small part of this. 

Therefore, even if GDP and consumption are growing quickly in Germany it’s not entirely clear that this would have a significant knock on effect on the countries that need it most.  The Netherlands, France and Italy are the most likely to see some boost. The IMF itself noted recently that using fiscal policy to boost Germany GDP would provide limited help for the eurozone. It ultimately also depends where Germany’s economic growth comes from, if driven by its own exports or government spending the impact would be even further limited.

2. Providing space for the periphery to boost exports

The theory here is that Germany ‘reflates’ allow wages and unit labour costs to grow and focuses its economy more on domestic consumption and investment rather than exports. This allows for the other eurozone economies to step in and export more, not least because they look relatively more competitive.

However, as the graphs above show (via UBS, click to enlarge), in many cases the struggling peripheral countries do not export the same goods as Germany (transport equipment, electrical equipment, chemicals), although there is some overlap on food and financial services. In any case, it’s far from clear that the struggling peripheral countries would be able to step into any breach left by Germany (particularly with heavy competition from emerging markets). Furthermore, many German exports used component parts from elsewhere in the EU, so decreasing them could actually have negative knock-on impact in certain sectors.

Another point worth keeping in mind is that a rapidly growing Germany would put added strain on the one-size-fits-all policy of the ECB. With the ECB now forecasting that interest rates will stay low for some time, if Germany continues along this growth path it may not be too long before the Bundesbank becomes concerned about the monetary policy being too lax.

It almost goes without saying that strong German growth is a good thing for the eurozone generally (breeds confidence and helps encourage investment) and strong economic growth should be the target for all countries. However, as the points above demonstrate, this does not mean it will be enough to drag the eurozone out of its crisis (i.e. it may be necessary but it is far from sufficient) and is certainly no panacea. The key issues to address remain the structural flaws in the eurozone and the lack of competitiveness within many of the peripheral economies.

Merkel and Letta shadowbox on 'growth' vs 'austerity'

New Italian PM Enrico Letta paid his first official visit to Germany yesterday, only hours after delivering his inaugural address to the Italian parliament. Much has been made of his strong 'pro-European' yet 'anti austerity' stance - so how would this go down with Die Kanzlerin? Here are some quotes from yesterday's press conference:

On 'growth' versus 'austerity'

Letta: "We have done our bit [on budget consolidation]…Europe has to implement growth policies."

Merkel: "We have to free ourselves from this misconception that growth and budget consolidation are opposed. Solid public finances are a precondition for growth. And growth is not only the state giving money, but it's creating conditions for small and medium enterprises to feel at home, to be able to invest and open up jobs. And for that we need structural reforms, good schools and universities, investments in research."

On national responsibility vs 'European Solidarity'

Letta: "In the past five years of crisis we did not find sufficient solutions because there was not enough Europe. This is my objective - and also that of Germany, because both our countries have a federalist vocation... If we reached these objectives [banking union, a fiscal and economic union and a political union] we could solve our domestic problems much easier."

Merkel: "We want to ensure Europe emerges from this crisis stronger than it went into it. As part of that every country must do its part."

On meeting EU targets

Letta: "How and where we will find the resources is a domestic matter. I don’t owe explanations to anyone. I’m not here to justify domestic choices... We have no intention of telling German citizens what they have to do, and we know German citizens have no intention of telling us what we have to do.”

Merkel: "Every country must complete its own tasks... [Italy] has already made significant progress on this path."

Overall, the tone of the press conference and meeting was fairly amicable and concilliatory. That said, there are clearly a number of potential flashpoints. For all the pro-European rhetoric, for Letta 'more Europe' clearly involves more financial help for Italy, be it via a bank resolution fund or debt-pooling and not more EU scrutiny of national tax and spending decisions which is the German approach - note Merkel specifically referred to the fiscal treaty as an "element of consolidation" and the ESM as "an element of solidarity".

As we've pointed out previously, Italy still faces a number of challenges - finding a way of balancing the books without money from the planned property tax (the cancellation of which was demanded by Berlusconi) and also re-starting the structural reform agenda which stalled under Monti following a promising start. Failure to achieve progress on these fronts will inevitably trigger tension with Germany.

A sign of things to come could be this comment from (German-born) Josefa Idem, Italy's new minister for Sports and Equal Opportunities who told ZDF that she "understands that the people most directly affected by the crisis and who draw a direct link with the austerity measures bear an aversion towards Mrs. Merkel."

Not everyone in François Hollande's party cares about Franco-German diplomacy...

French President François Hollande's Socialist Party will hold its 'Convention on Europe' in Paris on 16 June. Several working papers are currently being prepared as a basis for discussion among party members and supporters at the Convention. One of them has been leaked to Le Monde. And believe us, it contains some pretty strong stuff.

Two caveats before we start:

• We learn from the official website of the Convention that the papers do not reflect party policy "at this stage".

• The draft published by Le Monde could still be tweaked before the Convention.

Nevertheless, it does give a sense of the mood within the party. These are arguably the most 'explosive' excerpts:

"The communitarian project is today wounded by an alliance of circumstance between the Thatcherite rhetoric of the British Prime Minister - who only conceives a devalued à la carte Europe - and the selfish intransigence of Chancellor Merkel - who cares about nothing but the savings of depositors across the Rhine, Berlin's trade balance and her electoral future. In this context, France has today the only genuinely European government among the EU's big member states."

"Democratic confrontation with the European right means political confrontation with the German right. Franco-German friendship is not the friendship between France and Chancellor Merkel's European policy."

"[Former French President Nicolas] Sarkozy had imposed a certain practice: not Franco-German friendship, but France's alignment to Germany."

The document concludes the party should stand behind President Hollande and support him "in his arm wrestling against the austerity Chancellor [yes, it's Angela again] and the European Conservatives."

It's hard to imagine the French government or Hollande himself publicly endorsing this document, but the sense of frustration is palpable and points to the widely recognised relative decline of French influence over both the direction of the 'Franco-German motor' and the EU more widely. It signals the mood within Hollande's party is becoming increasing hostile to Mrs Merkel, and that the party wants the President to be tougher in confronting the German Chancellor. Not a call Hollande can keep ignoring forever. But also a fight, deep down, he knows he is probably not going to win.

Is the IMF turning bearish on Spain?

It’s been a busy week for the IMF, releasing their latest iterations of the World Economic Outlook, Global Financial Stability Report and the Fiscal Monitor. We’ve been poring over the reports and will continue to do so (see here for some initial thoughts on the WEO). One forecast in particular caught our eye – Spain's.

The IMF seems to have turned significantly more pessimistic on the prospect of a Spanish recovery. The charts below provide a comparison with the previous WEO forecasts (highlighting how these forecasts tend to be overly optimistic) - which very much confirms what we have noted before about the real risks in Spain.

The latest projections for the Spanish deficit (the dark blue line in the above chart) definitely represent a break from previous forecasts. In particular, the forecast for 2014 is 2.3% of GDP higher than in October. The IMF says this is:

“Reflecting the worse unemployment outlook and the lack of specified medium-term measures.”

Translation: the government does not have the necessary budget cuts and reforms in place to meet its desired deficit path – step it up Rajoy.

Such an increase manifests itself in the debt level projections as well. Worryingly, these no longer peak in 2015/16 and level off thereafter. Instead, Spanish debt to GDP is forecast to reach 111% in 2018 and looks set to keep growing rather than peaking and levelling off.

Effectively, this graph also highlights how the forecasts have progressed as the crisis in Spain has evolved from from financial, to a sovereign liquidity crisis and now into a sovereign solvency one. As the IMF notes, sustaining this will be tough:

“[Countries such as Spain] would need to maintain large primary surpluses over the medium term. In the absence of entitlement reforms, projected increases in age-related spending mean that additional measures will still be needed over time, however, to keep the primary surplus constant.”

Translation: Spain needs to run large primary surpluses for a long time, but in the face of increasing welfare and pension spending, this will need to come from a series of additional and painful cuts.

So the IMF does not paint a pretty picture for Spain. Longer and deeper recession, larger deficits at a time when it needs to be moving to surplus and increasing debt, in turn raising questions about the country's solvency. Let’s not forget, that’s before bringing the bust banking sector into the discussion. Plenty for Rajoy to get on with then…

Update 16:20 18/04/13:
Christine Lagarde has reportedly suggested that Spain should be allowed to ease its austerity programme. Lagarde argues that, although Spain needs fiscal consolidation, it does not need to be front loaded. Such an argument is not going to sit well with the eurozone and will increase the tensions within the Troika (some of which were outlined in this FT article earlier today). As the graph below shows such an approach may not fit well with the IMF own growth forecasts. Even with a 7% deficit, growth next year in Spain will be 0.7% according to the IMF. How much more would need to be spent to get to a respectable 1.5% GDP growth? Double the deficit?

Maybe not something this extreme but with debt already heading towards an unsustainble path it's not clear that there is much scope for further spending, while markets may put pressure back onto Spain once again. This raises the prospect of a further bailout or transfers from other eurozone states, but as we pointed out at length yesterday, Lagarde is talking about something very different than removing austerity in that case.

Tackling the slow, painful decline: A bad day of economic data for the eurozone

Some have said the worst of the eurozone crisis is over – this morning’s economic data did not provide much support to their argument.

 

Top of the list are the growth figures for the eurozone in Q4 2012 – as a whole the bloc contracted by a massive 0.6%. Maybe not a huge surprise but still worse than most expected. Furthermore, there were few glimmers of hope. 

As the graph above shows, Germany posted a contraction of 0.6%, Italy 0.9% and Portugal a massive 1.8% (more on this in a minute). France’s 0.3% contraction looked relatively mild, although it confirmed that the French economy saw zero growth in 2012 – it also put pay to any hopes of the French government achieving its growth projections for 2013 or its deficit target (see here for more on this). For all of these countries, this was the worst quarterly growth performance in almost four years (2009Q1).

The Italian statistics agency confirmed that growth for 2012 was -2.2%, a timely reminder of Italy’s real problem – an endemic and chronic lack of economic growth. The absence of any credible policy for correcting this in the current electoral campaign should be of grave concern to all of Europe.

Portugal was undoubtedly the stand out performer, but not in a good way. The 1.8% contraction in the final quarter brought the annual real terms contraction in 2012 to 3.2%. This result, along with the German contraction (which was put down to a collapse in European demand for German exports), highlights the substantial risk of expecting export lead recoveries to materialise when the entire eurozone is in a recession. The stumbling growth in the US and China at the end of 2012 likely created a further drag.

In fact, the only countries to provide any strongly positive data were the smaller central and eastern European economies – particularly Estonia, Latvia and Lithuania. Some would highlight that these are the countries that have already completed a significant round of structural reforms and internal devaluation. In any case, they are far from large enough to help pull the rest of the eurozone out of its current slump.

Meanwhile, the Greek statistics agency Elstat also released its figures for Greek unemployment in November 2012. Overall unemployment reached 27%. As we have noted many times before, this far outstrips the EU/IMF/ECB troika estimate for the end of 2012 which was 24.4% (this is even after it was revised upwards significantly in the IMF’s January report on Greece).

More worryingly though, youth unemployment has reached a whopping 61.7%. Think about that figure - it's absolutely extraordinary, especially when compared to the fact that it was only 28% three years ago. We can’t help but wonder how long such high levels of unemployment can be sustained before the political and economic impact becomes too heavy for the state to carry alone (i.e. before Greece demands further eurozone funding and concessions on its reform programme). Again, the risk is that the very fabric of Greek society could start disintegrating under such sustained pressure.

There has been plenty of optimism around the eurozone recently, some of it warranted and we should relish this. But this data should be a timely reminder of, arguably, the biggest challenge of them all for the eurozone: how to reverse the trend of slow, grinding decline.

If EU leaders thought for one minute that there were room for complacency, they can think again.

French economy: "Bienvenue au Club Med!"

France’s National Statistics Institute (INSEE) and Eurostat have both confirmed that the French economy shrunk by 0.3% in the last quarter of 2012 - and according to INSEE the economy registered zero growth throughout 2012. President François Hollande is expected to soon revise down his painfully optimistic growth forecast of 0.8% for 2013. In the meantime, if anyone had any doubt as to what these figures mean for France, a comment piece on the front page of today's Le Figaro does the trick:

 

Hollande can always seek consolation in the fact that the figures for the rest of the Eurozone were pretty grim as well....

Another disastrous budget for Greece

This week saw the release of the Greek budget plan for 2013-2016 and it did not make for happy reading. The English version is yet to be released but below we reproduce some of the key facts and figures from the Greek report. The table below essentially sums up the report and the crushing blow it delivers to hopes of a Greek recovery:

Debt peaking at a 192% of GDP in 2014! Astonishing given that less than six months ago the EU/IMF/ECB Troika seemed supremely confident that Greek GDP could stabilise at 120% of GDP by 2020 and would peak in 2013 at only 167% of GDP. (It’s also worth checking out this FT Alphaville post which highlights just how wrong some of the previous estimates were).

It’s easy to say that Greece failed to fully implement reforms and adhere to the bailout conditions (which it did) but at some point the failure of policies themselves and the fudging of the numbers must be admitted.

To many of us all of this was already abundantly clear but the release of the official figures confirming it at least ensures that the political debate will need to be moved on – expect ‘Grexit’ discussions to return to the headlines with a vengeance.

There are also a few interesting nuggets in the budget which suggest to us that further revisions may be likely:

• Firstly, unemployment is expected to go from 22.4% this year to 22.8% next year and then decline to 17.1% in 2016. It’s hard to see how this can happen with both government and private spending expected to fall over this period, while there will also be plenty of labour market reforms which tend to increase unemployment, at least in the short term. 
• Despite dropping by 15% this year, investments are expected to fall by only 3.7% next year and then return to growth. Again this seems massively optimistic without a permanent fiscal transfer supporting Greece and remove the cloud of a Grexit which continues to deter investors. 
• Exports are expected to grow at an increasing rate over the next five years, despite the eurozone and the global economy potentially posting low levels of growth. 
• Private consumption is expected to fall by 7% next year (after 7.7% this year), and yet this is expected to be consistent with a 4.5% contraction in GDP rather than a 6.5% one seen this year. Combined with falling government spending and structural reform this is again hard to imagine. 
• Table 2.5 highlights what could happen if Greece does not implement its medium term fiscal strategy (aka. its austerity packages and structural reforms), putting debt at 220% of GDP in 2016. This highlights how easily the levels could once again veer off track if many of these unrealistic targets are not met. 

As we mentioned in our recent note, a two year extension will be far from enough for Greece and this budget further reinforces that fact. With it now out in the open, discussions over the next few weeks should focus on more than just Greece’s next two years, but the fundamental decision of whether Greece belongs in the euro.

Credit where its due: EU Patent office is a good deal for British and EU businesses

The creation of an EU patent office, somewhat overshadowed by the latest twist on the eurozone crisis rollercoaster, was one positive piece of news to emerge from the recent EU summit. As we have noted previously, this is not before time.

It has taken ages to agree a patent and it has now finally passed through the European Parliament via the use of the novel ‘enhanced cooperation procedure’ in order to overcome the objections of Spain and Italy, who are upset that not all EU languages are to be used (something that would have lumped a higher cost on users).

If they manage to sort out the outstanding issues (which unfortunately is a big if) for the first time a British inventor will only need to register a patent once to protect their work throughout the EU. If done right this should reduce costs and increase protection for the UK’s important knowledge based scientific and creative industries. In other words, good news for UK business. But as well as being good for UK and EU business, this is also interesting as it breaks two EU taboos:

• Firstly it's another example of a 'two speed' EU, (with the UK in the fast lane) implicitly acknowledging once again that the one size fits all EU Commission dogma no longer work as overarching basis for European cooperation.
• Secondly, if David Cameron’s statement is correct, it will exclude the costly involvement of the European Court of Justice, something two UK Parliamentary reports here, and here concluded would increase cost and give jurisdiction to a court with no expertise. 

We have long been a critic of the way the ECJ works so an acceptance that it cannot be the final arbiter of everything is good news and sets an important principle. Unfortunately, this is not a done deal yet. Unsurprisingly, the ECJ has already ruled that it must have jurisdiction, in a move that reflects poorly on the Luxembourg court.

Still credit to David Cameron and other EU leaders for taking a positive step to boost innovation and business growth. Sometimes "more Europe" can help.

Marshalling growth in Europe

If talking about growth could create economic growth then the eurozone would be flying right about now.

The latest in a long line of 'pro-growth' proposals for the eurozone looks to be the creation of a new ‘Marshall Plan’ to provide funding for investment projects in Europe. The plan, according to El Pais, is to attract €200bn in investment from the private sector to fund projects geared towards creating growth particularly in infrastructure, green energy and high technology.

Currently, there are few details on the plan available but the main mechanisms for achieving the funding seems to be:

-          Increase the European Investment Bank capital by €10bn, which it is claimed would boost the lending capacity by €60bn and overall investments by €180bn (we assume by some sort of match funding with the private sector or other public funding)

-          Use the remaining €11.5bn in the European Financial Stability Mechanism (EFSM) as initial capital to be leveraged in the private sector (again in a similar way to above)

Clearly, this would be an EU scheme rather than just a eurozone one with proportionate access and funding. This also means that as a contributor to the EIB and EFSM, the UK would be involved, effectively underwriting a chunk of the financing - which could potentially be controversial in Westminster. Remember that the provision and Treaty change designed to put the permanent euro bailout fund (European Stability Mechanism) on a legally sounder footing while simultaneously giving the UK guarantees that it will not be implicated in euro bailouts in future, is still to be ratified in the UK parliament.

This would of course not be a "bailout" though, but something quite different. We hesitate to pass judgement on such an undefined plan, but here are some of our initial thoughts:

-          In principle this could be a positive idea for Europe - we like the focus of the investment and if it is conducted in the right way, it could be worth the UK participating. However, it's hard not to be slightly sceptical about how Europe tends to go about these kinds of schemes, which could instantly undermine that case.

-         The EU's new found infatuation with leverage seems to continue with this idea (which is strange given its views on financial regulation and the causes of the financial crisis). The lack of detail aside, the numbers in the plan seem stretched, at best.

-          Given the fairly limited contribution of European funds we wonder why the private sector would suddenly be so keen to invest in these projects. The project assumes that there is a glut of unfunded investment projects in Europe but it’s not clear why this new fund would massive ramp up investment over its currently depressed levels – if the private sector isn’t funding these projects now, why or how would the fund change this? 

-          The massive injection of money into the banking sector through ECB lending has failed to stir bank lending to such projects and some have cited a lack of viable, risk-appropriate demand for these types of loans. It is possible that the glut of unfunded programmes is not as large as the Commission believes, so this fund would not be addressing the correct problem. 

-          The EU already provides a huge amount of funding, through mechanisms such as the structural funds, which go to similar aims of development and investment. As we recently pointed out these could be spent much more efficiently and have a larger impact. The EU should focus on improving and reforming its current spending plans before trying to create new huge funds with grand aims. 

-          If this fund does come into place there needs to be a rigorous and clearly defined criteria for providing funding, which should be based solely around the ‘growth’ potential or economic benefits of the plan. The EU has fallen short on this front in many other areas of spending.

-          The areas mentioned for providing growth (infrastructure, green energy and high technology) all sound very promising and beneficial but need a carefully differentiated approach (which isn't happening in the structural funds). For example, in many areas (see Spain and Portugal) infrastructure spending has been high for some time but delivered few growth benefits and little more is needed. As the CAP and structural funds show, mixing in scientific and environmental goals with economic objectives can become very messy. Although green energy and promoting new technologies are laudable aims they may not provide the best returns and may not be the most cost effective investments. The singular aim of growth should dictate investments rather than a convoluted over-arching strategy to attack many problems in Europe.

Unless these issues are addressed, we may just end up with another pot of European money being poorly targeted and failing to address a key problem.

How to make the EU’s farm policy work for jobs, growth and the environment

Open Europe has today published a new report looking at the EU’s farm policy – the Common Agricultural Policy (CAP) – and how it could and should be reformed. As we set out in the report, the UK gets a bad deal from the CAP, contributing £7.1bn more than it gets back over the current EU budget period. At the same time, the subsidies it receives are spent in a way that actively channels resources away from areas and sectors that could generate the most economic or environmental benefits.

Short of entirely liberalising the policy, Open Europe has proposed a radical overhaul, linking subsidies to measurable environmental benefits, while allowing productive farmers to opt in or out of the scheme. At the same time, the overall CAP budget would be rationalised, reducing the UK’s contribution to the EU budget by £7.3bn over seven years.

The full report can be downloaded here, but these are the key points:

- On-going negotiations over the EU’s long-term budget provide an opportunity for the UK to reverse the serious poverty of vision that has characterised British diplomacy and government thinking on CAP reform for decades – but the window for doing so is quickly closing.

- The UK remains a big loser from the CAP. Between 2007 and 2013, the UK will contribute £33.7bn to the CAP and get back £26.6bn; a net contribution of £7.1bn. Per hectare, the UK receives £188, compared to for example France, Germany and the Netherlands which receive £236, £251 and £346 respectively.

- There remains no clear link between the wealth of a country and how much it receives from the CAP. Latvia, for example, gets £115 per hectare from the EU’s Single Payment Scheme – the least out of all member states – despite average farmers’ income being only 35% of the EU average. By contrast, wealthier member states such as Ireland and France continue to do well out of the CAP.

- Despite a series of reforms, the main ‘benefit’ of the CAP is that on the whole, it is less damaging than it used to be. Owing to its arbitrary design and contradictory aims, the CAP fails to meet its own objectives of delivering bio-diversity, boosting farmers’ competitiveness and promoting rural jobs and economic development.

- The share of the CAP spent on explicit environmental aims in the UK is only 13.6%. By failing to differentiate between different types of land, direct CAP subsidies actively channel public resources away from where they could create the biggest environmental gain.

- At the same time, by providing income support irrespective of whether any meaningful economic activity takes place on a farm, direct CAP subsidies often act as an outright disincentive for farmers to modernise, in turn locking in unviable business models and hurting Europe’s competitiveness.

- The cost to consumers and taxpayers across Europe of the EU’s farm subsidies and tariffs now stands at €86.9bn – of this €52.5bn stems from CAP subsidies. If, hypothetically, the CAP and other EU measures to protect farming, such as tariffs, were fully liberalised and the money freed up were re-channelled to more productive areas of the economy, it could be worth a boost in output equivalent to €139bn or 1.1% of EU GDP. Britain would experience a boost in output of €14.2bn or the equivalent of 135,000 full-time and part-time jobs.

- Full liberalisation of the CAP would be economically viable. However, given the widely held belief that that there is still a role for the state to play in delivering objectives such as bio-diversity, land management and R&D, such an option is most likely to gain political support.

- Therefore, we propose a pragmatic mix: a new, radically revamped EU farm policy, allowing for resources to be effectively allocated to both production and environmental benefits while better targeting jobs and growth. This would involve four steps:

1) The current CAP structure would be replaced with a system of agri-environmental allowances. Funding for member states would be allocated according to environmental criteria, such as bio-diversity, but be administered nationally. Payments could then be transferred between farmers depending on where the environmental gain is the greatest.

2) After complying with some minimum environmental standards, farmers would then be free to opt in or out of this scheme, with those farmers wanting to focus exclusively on production being free to do so.

3) EU-level funding for rural economic development should be limited to the poorer member states only, and be migrated over to the EU’s structural funds. Farmers should also be able to qualify for time-limited support from a fund similar to the EU’s Globalisation Adjustment Fund, targeted at making farmers more competitive and able to move into other parts of the economy.

4) A limited pot of money for agriculture related R&D should remain at the EU level.

- By simultaneously streamlining the CAP budget, such a system would reduce the UK’s contribution to the EU budget by £7.3bn over seven years.

A new year, the same old problems...

Ahead of the first (full) EU summit of the new year, we've put together our thoughts on what progress to expect.

As per usual there are lots of topics to be discussed but we don’t expect too many concrete decisions. We’d expect a final draft of the euro fiscal pact to be completed, some progress on ESM - the eurozone's permanent bailout fund - and a commitment to "growth and jobs" (as opposed to recession and unemployment..?). Huge questions over Greece and size of bailout funds will probably remain. Below we outline the key issues to watch out for (take 2):

Fiscal pact: This should be last round of discussions on the new European treaty. The aim has always been to have the final draft completed by end of January. However, there are still a few issues which need to be resolved.

The key interaction is between how the rules will apply to those non-eurozone which sign the pact and how much influence they will have (i.e. how many meetings they get to attend and what decisions they will have an impact on). Sweden, Poland, Denmark and the Czech Republic will make their decision on whether to sign based on how this plays out. The final agreement won’t be finalised as the Czechs and Irish will still have to decide whether to hold a referendum on the treaty. Expect it all to be tied up at the March summit.

Our bet is on the Poles, Danes and Swedes signing up if they're guaranteed some sort of place at the table and if the rules of pact actually don't apply to them - creating a rather bizarre situation.

The UK and the use of EU institutions: We suspect that Cameron will reluctantly accept the formulation in the fourth draft of the fiscal compact which gives the ECJ the right to slap fines on member states for not implementing the pact's spending ceilings. Technically, this marks an overlap between the fiscal compact and the EU treaties - something which Cameron has argued against in the past.

ESM treaty: Behind the scenes negotiations have been on-going, so the draft should be fairly far along. The biggest sticking point was the use of Qualified Majority Voting (QMV) to make decisions within the ESM, which Finland objected to. There now looks to be a compromise. The Finnish Constitutional Committee announced today that it approves of the new wording in the ESM treaty, whereby QMV is used to disburse loans but for any change in the size of the ESM a unanimous decision is needed. The Grand Committee (representing the Finnish Parliament) will rule on Monday and is expected to support this position. This is pretty big.

Additionally, there should also be a discussion on the size of the ESM and whether the ESM and EFSF can run in parallel. It's hard to read Germany on this issue. There have been indications that Germany may be willing to let ESM and EFSF run together, but it would want the fiscal pact and Greece sorted before it is considered. It's likely the topic will be broached but final decision will be delayed until March.

Greek restructuring: EU leaders are unlikely to have a deal ready to present at the meeting so it may be more of a general discussion. Even if a deal is achieved, which reconciles the differences between Greece and its bondholders over the level of interest paid on the new bonds, there is still the huge question of holdouts and ECB. Expect these issues to be covered along with talk of increasing the size of the second Greek bailout and losses for public sector - but don't expect any big movements (at least not publicly).

Growth and jobs agenda: EU leaders have been pushing this 'new' agenda recently. After coming in for massive criticism for their undying commitment to austerity, they are keen to focus on boosting competitiveness, promoting growth, creating jobs and the like. Despite that, as of yet a coherent policy agenda to achieve this has not been formulated - most of the time there is just a broad commitment to ‘structural reforms’.

We expect much of the same from this meeting - leaders (David Cameron in particular) will play up the renewed focus on growth rather than just austerity but it remains unclear how much difference the EU can make on this front. Ultimately, national governments need to push ahead with long term changes to the structure of their economies (labour market reforms, increased education and training, investment in R&D, increased competition etc.) This will take time, money and political will, all of which the eurozone is short of at the moment.

Berlusconi's choice

Over on EUobserver we look at Italy - and what the country now needs to do in order to secure a future inside the eurozone.

We note,

Following recent market panic, the European Central Bank’s (ECB) decision to step in and buy Italian bonds has given Rome some breathing space. Market fears were driven by a frightfully simple prospect: if Italy, the EU’s fourth largest economy, goes, so does the euro.

To avoid the worst, Italy now has one, possibly final, chance to push for radical economic reform and break its chronic growth problem. Failing this, Silvio Berlusconi & Co. may have to plan for a future outside the single currency.

....The current period of relief may prove short-lived since the ECB’s lifeline comes with a likely cut-off date. Italy is simply too big to bail. With its gigantic €1.8 trillion public debt, neither the ECB nor foreign governments can guarantee Italy’s finances in the long-term.

We note that, in order for Italy to get out of the woods, several things need to happen: Berlusconi has to go, the centre-right parties need to form a credible coalition (as a left-leaning coalition is likely to block vital pro-growth reforms), the regions need to accept cuts and reforms - and, most importantly, we note that,

Freeing up the labour market is essential: Radical reform of the labour market should be the top priority for any Italian government. Firing and hiring simply has to become far easier, which in turn lowers barriers to entering the job market. In addition, the tax burden on businesses should be reduced, particularly on SMEs where Italy’s economic strength lies. At the end of the day, Italy cannot live on austerity alone. It’s these kinds of reforms that will win investors’ confidence.

We conclude,

Will all these reforms take place? We shall see. But both Italy and Europe need to be fully aware of the consequences of Rome failing to deliver deep-rooted and necessary change. It’s time to finally bite the bullet or Berlusconi may soon have to add yet another, less than flattering point of note to his CV: bringing down the eurozone.

Read the full piece here.

Britain's growth: Europe remains the X factor

Conservative Home has launched a "growth manifesto" with contributions from a number of UK thank-tanks with the aim of providing ideas for how to return Britain to growth ("Here you go George; A Growth Manifesto from London's think tanks", is how the piece is aptly titled). 0.2% second quarter GDP growth is hardly impressive so ideas are certainly needed.

We've chimed in with our own thoughts, focusing on a long-term solution to the eurozone crisis in combination with pro-growth, liberalising measures in Europe (save on capital requirements for banks, where tougher regulation is needed). Like Mervyn King and others, we believe that the eurozone crisis remains the biggest threat to the UK's financial stability. But as we argued in the Sunday Telegraph last week, amid fears of another nasty economic downturn in Euroland - and the contracted demand for UK exports that comes with it - the crisis and the measures in its wake are also a direct threat to UK growth.

In fact, a large-scale meltdown in the eurozone could send the UK straight back into recession. The point being that fudging it - which EU leaders are currently doing - is a risky strategy. Here are our thoughts:

The Government needs to push for a long-term solution to the eurozone debt crisis – bailouts aren’t working, debt restructuring will be needed. The longer the crisis goes on, the worse the prospects for eurozone growth and stability look and, as our biggest trading partner, this will have an impact on the UK economy. In the medium-term the UK needs to seek allies in pushing for a better-functioning single market, including deregulation, removing cross-border barriers to services and digital industries, and protecting the interests of the City of London from the EU’s new financial supervisory architecture. This includes securing the flexibility to apply capital requirements for banks as the UK sees fit. In the longer term, the UK should look to diversify its trade away from the eurozone, tapping into the growth potential of emerging markets, which will be necessary in any case but also provides a Plan B if the eurozone fails to get its act together. The UK also needs to continue to push for a reduction in EU external trade barriers and encourage the expansion of free trade agreements with other economies/trading blocs.