Commission forecasts paint a less than optimistic picture for eurozone outlook

The European Commission has this morning released its Autumn 2014 Economic forecasts. While these forecasts can often be quite mundane owing to the very managed message they are trying to send, this set look to be a bit different (see here for our take on Winter 2014 and Autumn 2013). Maybe unsurprisingly the tone to more sceptical, critical and possibly realistic. Below outline some interesting themes.

Another downward growth revision
Once again growth for the Eurozone has been revised down. The previous forecast saw 1.2% and 1.8% growth in 2014 and 2015 respectively. The new forecast predicts 0.8% and 1.1% respectively, quite a significant downward revision, especially since growth next year is now expected to be below the original forecast for this year. The initial blame (in the press release) for this revision seems to be laid at the feet of “increasing geopolitical risks and less favourable world economic prospects”. However, that raises the question of why it is seen as enduring up to 2016. In the report itself the assessment is thankfully more candid highlighting “incomplete internal and external adjustment” and “low productivity gains”.

More realism about the labour market
There is a wider acceptance in these forecasts that unemployment will remain elevated for some time and that differences in labour market performance will persist. That said, at the moment any real prospect on employment growth in the Eurozone seems optimistic.

Bad news in nearly all the large economies
France and Germany’s growth prospects for this year have been revised downwards to 0.3% and 1.3%, from 1% and 1.8% respectively. Italy is expected to contract by 0.4% this year and only grow 0.6% and 1.1% in 2015 and 2016 respectively. Given that these three countries account for nearly 60% of Eurozone GDP this suggests a very poor outlook for the Eurozone with growth risks tilted to the downside. In general, the core vs. periphery split is less clear in this report, at least in growth terms as many countries are now acting as a drag on the Eurozone economy for a number of reasons.

Significant and increasing reliance on domestic over external demand
Early on in the crisis there was a clear focus on facilitating export led recoveries, often in the German model. However, over the past 12 – 18 months this has shifted, possibly driven by global economic weakness, and these forecasts finalise the shift. The Commission itself says,  “Net exports are likely to contribute only marginally to GDP growth over the forecast horizon”. Spain is a prime example of this, see here for a longer discussion of the issue.

While finding a balance between the two is important (we cannot have 18 Germanys in the Eurozone) the shift may have been too stark. Let’s not forget that there is still a huge amount of public and private debt (both household and corporate) in the Eurozone, especially in problem countries. This will limit potential domestic demand growth. So while the flows are shifting in a way which should see an uptick in domestic demand, we should not forget that the huge stock of debt may provide a ceiling on this as a driver of growth.

Low inflation is here to stay
The Commission has also downgraded its inflation forecast with CPI expected to be 0.8% in 2015 compared to previous forecast of 1.2%, while it is only expected to be 1.5% in 2016. The forecast for 2015 is below the ECB’s of 1.1% but the 2016 is above the ECB’s which is 1.4%. Interestingly, the Commission continues to make the case that “low, or negative, inflation rates as part of [some countries] inevitable adjustment process”. This is an argument which has been absent all recent ECB press conferences. In terms of deflation, the Commission sides with the ECB, saying the risks of outright deflation remain low.

We’ll update the blog throughout the day as we pour over the 185 page report. But for now, we’ll leave you with a thought from Commissioner Jyrki Katainen in the press conference, when asked how much the forecasts can be trusted given a history of being incorrect he simply responded, “Nobody knows”. Quite.

Athens strikes another bargain in Brussels, but how long will this one last?

As we noted last week on CNBC, a deal was always likely this time round in Greece:

"We've got German elections coming up in September and no one wants to have that talk of how we're going to fund Greece for the next three or four years. So they just want to kick the can down the road until after the elections…They will come to some agreement but it's clear that Greece is well behind track on its programme once again and it's only a matter of time before a new funding gap opens there."

One was eventually reached yesterday morning with details filtering out overnight.

How much will be disbursed and when?

• The eurozone will provide €2.5bn this month and €500m in October, while eurozone central banks will provide €1.5bn and €500m at the same time by releasing profits from their holdings of Greek government bonds. This should give Greece enough cash to cover costs and payoff the €2.2bn of government debt maturing in August.
• The IMF will hold a meeting later this month where it is expected to agree to release its next €1.8bn share of the bailout.
• The staggered pay-out of this €6.8bn will allow the eurozone to enforce more conditionality, meaning it could delay the future tranches if Greece does not stick to its reform programme.
• Once this round of funding is complete, Greece will have received around €208bn out of a total €246bn committed.

What does Greece need to do?

• The bargain comes with strict conditions on Greece (as always), particularly in terms of civil servant cuts on which Greece seems to have fallen far behind. Greece must put 12,500 civil servants in the labour mobility scheme within the next few weeks (where they receive reduced pay and are sacked within a year if they do not find a new position).
• This must be doubled by the end of the year, while 15,000 must be laid off by the end of 2014.
• Greece must also work to step up reform of the tax system, tackling evasion and improving collection of back taxes. This is obviously easier said than done and has been a target from the beginning, no details yet as to how this time round will be any different.
• Must close the funding gap in the healthcare provider EOPYY which totals around €1bn. Again no details as to how and when exactly this will be closed.

Unanswered questions

• On top of the ones hinted at above, the key unanswered question remains, how will Greece fund itself once the bailout runs out? The eurozone has already further committed to €11bn in aid (unlikely to be in the form of direct funds) in 2014 and 2015 although it is yet to identify where this will come from. Eurogroup head Jeroen Dijsselbloem dismissed such concerns saying, "If there is a financing gap it will be at the end of 2014, which will allow us plenty of time to deal with it," which provides little comfort given the delays in dealing with other eurozone problems.
• Can the government actually push through all these measures with its slim majority? We expect it will probably be able to (just), but it will be the first real test for the new coalition and will provide a good bellwether of how it will fair in the coming months.
• What is happening to the closed state broadcaster ERT? This remains unclear. This is important not just for political reasons (still has the potential to expose divisions in the coalition) but also since the 2,600 employees could provide a big boost towards meeting the targets for civil servant cuts (the real reason behind the closure in the first place we suspect).
• Another key aspect of the recent funding gap was the reluctance of national central banks to rollover their holdings of Greek bonds (thereby reducing the amount Greece has to pay off). It’s not clear whether this has been done or will be done, although comments from officials this morning suggest it may not yet be finalised.

Another bargain very much along the usual lines of cash-for-reforms. Questions over Greece still loom large, it is not clear that they will be able to push through these public sector reforms having failed many times before. Given the lukewarm comments from the Troika it seems that even they expect another funding gap to open soon. Meanwhile as the end of the bailout approaches the fundamental issue which the eurozone has been avoiding for some time – how to fund Greece for the next decade – will need to be dealt with.

Europe's most important political party hits the campaign trail: a sneak peak at the EU section of CDU/CSU's election manifesto

We've managed to get our hands on the CDU/CSU's draft manifesto for September's federal elections, which is not due to be officially presented until Sunday. Given that the CDU (which always runs jointly with its Bavarian sister party CSU) is the single most important party in European politics by a mile, this is definitely one to watch.

Interestingly, the first section of the manifesto is entitled "Germany's future in Europe", indicating how closely these two issues are linked.
Aside from the obligatory pro-European rhetoric, here are the key points we've picked out regarding what the parties will campaign for and against on the EU/eurozone:

CDU/CSU support:

-  More EU oversight over national budgets with sanctions for breaching the Growth and Stability Pact,
-  So-called ‘Competition Pacts’, i.e. enforceable contracts between the Commission and member states on economic reforms,
-  Increased labour mobility, including greater co-ordination on the recognition of academic degrees and professional qualifications, as well as on access to social security,
-  Retaining the Franco-German axis as the "motor" of European integration, while at the same time wanting to draw Poland - described as the most important partner among the new member states - closer into this fold,
-  Pushing German as one of the main EU languages (along with English and French).

CDU/CSU oppose:

-   Sovereign debt-pooling via 'eurobonds',
-   An EU-wide guarantee scheme for bank deposits,
-   A split between the eurozone and the wider EU (“We would prefer to progress with all EU partners”).

So broadly no big surprises, German support for economic reforms and budgetary restraint on one hand and opposition to debt-pooling on the other is well established, although we note the concept of giving the Commission greater powers was not included in the recent Franco-German proposals on the eurozone. The explicit commitment to pushing for greater use of German within the EU hints at a more assertive Germany that is more at ease with itself.

Tellingly, the UK is not mentioned explicitly in the EU section, although the co-operation between the two countries on tax transparency is mentioned elsewhere in the document. From a wider UK perspective, the focus on economic reform and competitiveness is welcome, although the UK would not want to give the Commission greater competence in this area. The UK would also welcome any moves to clarify the rules governing EU migrants' access to domestic welfare systems - though it's going to be very interesting to see more details on transferability of benefits, as that's something many in the UK are keen to limit.

We will of course keep you updated as the campaign progresses.

Despite much fanfare, the European Commission recommends much of the same for the eurozone

The Commission has today released its country-specific recommendations on economic policy. Below, we highlight the most important suggestions made to some of the key eurozone countries.

SPAIN

• According to the European Commission, Spain should “improve the efficiency and quality of public expenditure at all levels of government”. Clearly, this is easier said than done, given the well-known problems the Spanish government is having in trying to rein in regional spending.
• The European Commission also seems to suggest that the 2012 labour market reform – one of the flagship measures adopted by Mariano Rajoy’s government – may need tweaks. In particular, Spain should reform its active labour market policies.
• Spain should also push ahead with the liberalisation of closed professions and improve the business environment in general – for instance by cutting the amount of paperwork, a notorious issue in the country.
• Spain should “further limit the application of VAT rates”. This might be controversial, as the Spanish government has said several times it is opposed to further VAT hikes.
• According to the Commission, the reform of Spain’s pension system should be finalised by the end of the year.

FRANCE

The recommendations for France include quite a few suggestions which may be hard to digest for François Hollande’s socialist government.

• France should do more to cut labour costs, in particular by reducing social security contributions for employers.
• The European Commission says France should adopt new measures by the end of the year to “bring its pension system into balance in a sustainable manner no later than 2020.” The Commission suggests various ways of doing this, including “adapting indexation rules” (remove/reform the link between inflation and pensions increases, in plain English) and raise the retirement age. This is unlikely to go down well in Paris.
• France should improve the business environment and help its firms become more competitive;
• France’s unemployment benefit system should be “urgently” reformed, so that it is sustainable but also “provides adequate incentives to return to work”.
• France should do more to tackle labour market segmentation, and remove “unjustified restrictions in the access to and exercise of professional services.”

ITALY

As we noted several times, Mario Monti’s technocratic government did a good job in cutting Italy’s deficit – less so in implementing structural reforms. Here is what the European Commission would like Italy to do:

• Make sure that the reforms initiated by Monti's government are properly implemented (some of them require enacting legislation).
• Push ahead with labour market reform. Wages should be better aligned to productivity, and more should be done to bring young people and women into work.
• The tax burden should move from labour and capital to consumption, property and the environment. Sure enough, this is going to be controversial, given that the new Italian government is trying to avoid a VAT increase scheduled by its predecessor for 1 July 2013 and is also considering scrapping a property tax on first homes.
• Continue with liberalisation of the services market and opening up of closed professions – which seems to be an issue affecting all the Mediterranean eurozone countries.
• Needless to say, all this has to happen without breaching the EU’s deficit limit of 3% of GDP and in parallel to a reduction of Italy’s gigantic public debt (forecast to be over 132% of GDP in 2014).

SLOVENIA

• As we have previously warned, the Commission flags up the risk of the heavily indebted corporate sector and how this in closely intertwined with the fate of shaky banks.
• Of the largest domestic banks the Commission warns, “Their dependence on the state for capital is a substantial threat to the economy” and that “Further recapitalisations are foreseen in the stability programme”. The Commission does not give an estimate of the recap needs but it’s clear there is concern that it could impact the Slovenian economic situation. To this end it also called for an independent review of the Slovenian banking sector.
• Government growth forecasts are seen to be overly optimistic, particularly next year's, this could be further hampered by the banking sector.
• Significant push needed on cutting wages and increasing productivity, true in most places but especially on Slovenia when costs have been on a rapid rise in recent years.
• Need to push on with privatisations and come up with a clear policy framework to do so. More structure needed, particularly if investors are to be convinced.
• “Further reform efforts are required to improve the sustainability of pension expenditure in the long-term, including through aligning the statutory retirement age with gains in life expectancy and by further restricting early retirement.” – numerous concerns expressed about long term liabilities of the state.

GERMANY

• “Germany should do more to open up their services sector by removing unjustified restrictions and barriers to entry, thereby leading to lower price levels, making services more affordable for lower income groups.” – particularly calls for the opening up of public procurement, professional services and retail services.
• “Sustain conditions that enable wage growth to support domestic demand.” – although it sounds innocuous this could be very controversial in Germany. It essentially seems to endorse the calls for Germany to spend more and allow inflation to help rebalance the eurozone. Germans fear of inflation is well known but they also fear a decrease in the competitiveness.

BELGIUM

Some press reports were (perhaps a bit hurriedly, given how the EU works) suggesting that Belgium could today become the first eurozone country to face sanctions for missing its deficit targets. But EU Economic and Monetary Affairs Commissioner Olli Rehn just told journalists in Brussels that “it would be neither fair or legally sound to apply fines retroactively”, so Elio Di Rupo & co. have been let off the hook for now. These are the key recommendations:

• Transpose the ‘balanced budget rule’ enshrined in the fiscal treaty into national law; 
•  Step up efforts to “close the gap between the effective and statutory retirement age”. In other words, the European Commission thinks there are too many early retirements in Belgium at the moment. On pensions, Belgium should also “accelerate the adoption of a decision to link the statutory retirement age to life expectancy” – which could mean further retirement age increases in future; 
•  Less taxes on labour and better alignment of wages to productivity to restore competitiveness; 
• Remove barriers in the services sector. 

So, for all the talk of this being the ‘end of austerity’ or ‘austerity in retreat’, is much really changing? Sure, there is some tinkering with timelines for deficit reduction (Spain, France and others have been given more time to cut public deficit), but ultimately the eurozone is still going along the same policy path - just slightly more slowly. Cases in point are the countries above, since the clear themes running through all of them are the need for structural reform, welfare reform, fiscal consolidation and liberalising the economy. These are things which have long been advocated and are clearly necessary. The question remains whether they can all be done at the same time by a group of countries which are closely interlinked, and many of which are currently in recession.

Is the academic premise for austerity in the eurozone crumbling? Not quite…

A mini-storm has been whipped up in the economic community overnight after a paper was published highlighting some flaws in the widely cited Reinhart & Rogoff paper ‘Growth in a time of debt’.

A quick recap for those of you not familiar with the paper. It essentially argues that high debt levels are associated with low economic growth. It bases its analysis on data from 44 countries over the past 200 years. It also notes that this relationship gets stronger once debt exceeds 90% of GDP. The paper has been widely cited in defence of and in support for ‘austerity’ – by politicians in both the US and Europe (notably Olli Rehn in respect to the eurozone crisis).

The new research released challenged Reinhart & Rogoff’s (R&R) findings, on the basis of an excel error (oops), data omissions and incorrectly weighting of data. There has been plenty written about which side is correct – you can see a summary of criticisms here and R&R’s responses here and here.

The question that interests us is not necessarily the intricacies of this academic back and forth. To be honest, it is obvious that there is no clear single threshold above which debt begins to impact growth in all countries and that often specific historical experiences in certain countries may not mean much for policies in different times and places (see this Ed Hugh post for a good summary). This is particularly true given some of the unique constraints of the eurozone crisis.

But given that some people are seeing this as a damning indictment of the backing for ‘austerity’, will this have any impact on the approach to the eurozone crisis?

In a word, no. Here are a few reasons why:

• R&R research aside it is clear to everyone that Greece, Portugal and Ireland were insolvent, it was market pressure that pushed them into a bailout. Reducing the debt level is a vital part of their reform, while it also serve to counter the significant moral hazard that comes with a bailout.
• Similar constraints apply in Spain, Italy, Cyprus and Slovenia. With elevated borrowing costs they cannot expand fiscal policy without coming up against greater market pressure and pushing their average interest costs well above their growth rates (especially in the short run).
• Therefore, arguing for the end of austerity in these countries is actually arguing for fiscal transfers from the rest of the eurozone, since they do not have much, if any, room to expand spending. This is ultimately where the debate is at, it is not about austerity or spending, it is about whether the stronger countries are willing to provide the transfers – be it through banking union or fiscal union – to keep the eurozone together in the longer run and create the architecture necessary so that it can withstand future shocks. If they are not then they have to face the prospect of breaking up or decreasing the size of the eurozone.
• The constraints which apply also extend much further than just public debt. As we have seen in Spain, Ireland and Cyprus (and are seeing in Slovenia) the levels of private sector and banking sector debt are equally important. The macro picture is much more complex than just the level of public debt and economic growth. The problems in the crisis are a mix of fiscal, banking and structural.
• Austerity is more than just cutting spending. It has become a catch-all term for some very necessary reforms to improve competitiveness and productivity in the eurozone. Even if spending could be increased, these reforms would be needed, although admittedly the fallout (increased unemployment in many cases and massive political backlash) might be more bearable – but as noted above, this isn’t really possible in many of the worst cases.
• The logic behind the current approach is also strongly driven by Germany’s own economic experience in the late 1990s and early 2000s, which proved very effective in turning the country around. The main issue here is not whether the approach itself is correct or not (since it clearly did work there), but the scope in which it is applied. It is clear that you cannot have 17 Germanys with economies driven by exports in a single currency bloc where the countries predominantly trade with each other (it might help in the short term but its not clear it is a sustainable long term economic model for the bloc).

So what academics (and policymakers) really should debate is whether fiscal transfers are possible and/or desirable.  Proving or disproving R&R is neither here nor there when it comes to dealing with the eurozone crisis.

Who’s next in line in the eurozone crisis? Portugal and Slovenia are the prime candidates

In anticipation of tomorrow's eurozone finance ministers meeting (which will discuss finalising the Cypriot bailout and potentially extending the bailout loans given to Portugal and Ireland) Open Europe has published a new briefing looking at who might be next in the eurozone - our prime candidates are Portugal (for the second time) and Slovenia.

Key points

Both Portugal and Slovenia could need external assistance of some sort.

Portugal 

• Domestic demand, government spending and investment are contracting sharply, leaving the country heavily reliant on uncertain export growth to drive the economy. 
• By cutting wages and costs at home (internal devaluation), Portugal has in recent years improved its level of competitiveness in the eurozone relative to Germany. However, this trend actually started to reverse sharply in 2012, meaning that the divergence between countries such as Portugal and Germany has begun growing again – exactly the sort of imbalance the eurozone is seeking to close. 

• In its austerity efforts, Portugal is now coming up against serious political and constitutional limits. For the second time, the country’s constitutional court has ruled against public sector wage cuts – a key plank in the country’s EU-mandated austerity plan – while the previous political consensus in the parliament for austerity has evaporated.
• In combination, it will be increasingly difficult for Portugal to sell austerity at home and consequently to negotiate its bailout terms with creditor countries abroad.
• Portugal may well need some further financial assistance before long. It is unlikely to take the form of a full second bailout, but could involve use of the ECB’s OMT bond-buying programme, assuming Portugal can return to the markets fully beforehand (even briefly). 

Slovenia

• Slovenia is not Cyprus – in fact it is much more like Spain. Its banks are significantly undercapitalised with toxic loans now standing at 18% of GDP. Banks only have provisions to cover less than half the potential losses resulting from these loans.

• At the same time, a heavily indebted private sector is now desperately trying to get debt off its books, which alongside continued austerity and lack of investment, have caused growth to plummet.
• Though a full bailout is unlikely, the country could soon need an EU rescue package worth between €1 billion and €4 billion (between 3% and 11% of GDP) to help restructure the country’s bust and mismanaged banks.
• Such a plan is likely to include losses for shareholder (bail-ins) but, unlike in Cyprus, it may not hit large (uninsured) depositors and there will be no attempt whatsoever at taxing smaller (insured) depositors.

To read the full briefing, click here.

The OECD, bearer of bad news at Christmas?

A quick post on a topic which we have already explored in our internal devaluation paper and plan to look at in more detail in the New Year: competitiveness in the eurozone.

The OECD released it latest assessment of unit labour costs (ULCs) in the eurozone a couple of days ago and they do not make pretty reading for Italy or France and only slightly better for Spain:

(The graph shows ULCs indexed to 100 in year 2000. Greece= light red, Spain= green, Germany= dark red, Italy= blue  and France = turquoise).

ULCs are often taken as a measure of a country’s competitiveness, it is by no means the only measure but it is a useful indicator of the situation. As the graph above shows Italy will have higher ULCs than Spain, Greece and, obviously, Germany at the end of this year. This trend will only get worse and France could well find itself in a similar position in 2013/14 if things continue on their current path.

This highlights a point which we have made previously – for all his good work on the fiscal side, Italian Prime Minister Mario Monti has failed to provide sufficient reform of the labour market or boost productivity and improve the business climate (other areas which would also help improve the country’s competitiveness). Elections in Italy in early 2013 mean there will be little opportunity for reform in the first quarter of the year. That may be irrelevant depending on the format of the new government – there is no guarantee of a stable pro-reform coalition in Italy.

The results are similarly worrying for France which can ill afford to fall behind other eurozone states, not least because many of these countries are also improving their budget and current account deficits, while making significant product market reforms and deregulating – all of which the French government has shown little willingness to do.

As for Spain and Greece the reading is a bit more positive with their adjustments clearly having some impact – although as the OECD notes much of this has come from cuts to employment and falling domestic demand rather than successful reform. It is also clear that there is some way to go before they reach the levels of Germany (or get firmly within the bounds of acceptable differences, as we have pointed out before). With unemployment already sky-high in both places this remaining adjustment is likely to be painful.

Plenty for eurozone governments to ponder over the festive period then.

EU ironies: The Troika meets the Working Time Directive?

Oh the irony. The EU/ECB/IMF troika are now working their ever living tails off to push the Greeks and Portuguese towards more flexible labour markets, and less top-down regulation – and the European Commission is, in parallel, putting pressure on Italy and Spain to do the same. Simultaneously, however, the same European Commission is clinging on like a leech to the most top-down piece of labour market law imaginable (well almost): the EU’s Working Time Directive (WTD).

Well, these twin efforts might now be heading for a clash. Reports floating around yesterday suggested that the EU/IMF/ECB troika wants Greece to do more to flush out its rigid labour market by, amongst other things, raising the maximum number of working days per week to six. The reports are still sketchy - supposedly from leaked emails – so should be taken with a pinch of salt. Still, it paves the way for a pretty weird situation.

The leaked plans suggested the troika would demand the following to boost flexibility of labour arrangements:

• Increase the number of maximum workdays to 6 days per week for all sectors.
• Set the minimum daily rest to 11 hours.
• Delink the working hours of employees from the opening hours of the establishment.
• Eliminate restrictions on minimum/maximum time between morning and afternoon shifts.
• Allow the consecutive two week leave to be taken anytime during the year in seasonal sectors. 

Now the Working Time Directive:

• A maximum working week of 48 hours
• A rest period of 11 consecutive hours a day
• A rest break when the day is longer than six hours
• A minimum of one rest day per week 

In addition, a range of ECJ cases have extended the scope of the WTD even further (sick days spent on holiday can be reclaimed, doctors who sleep on-call are actively working etc).

The latest Troika plans, if true, would not break the WTD it seems, but they’re clearly taking Greece to the limits of what is permissible under EU law – lest they want to push Greece to seek a UK-style opt-out from the WTD (leading to a bizarre scenario, whereby the Commission urges an opt-out from its own rules). One step further and the acquis communautaire would get in the way. In addition, a hardworking Greek who wants to follow the Troika’s recommendations by putting in a six day working week, better be sure to clock out right on time, after eight hours have gone by, or he would be engaging in activities illegal under EU law.

This raises a second question: if the Troika was tasked with working out a competitiveness plan for the entire EU, would the WTD – and many other onerous EU regulations, and the EU budget for that matter – survive?

We suspect not.

Spain takes centre stage

It was a torrid day for Spain in the markets yesterday, borrowing costs soared (the 10 year topped 5.96% at one point) and the Spanish stock market plummeted. As we predicted last week, fears over the Spanish economy are beginning to crystallise in the minds of investors.

So what triggered the market fears yesterday?

Well, as we’ve pointed out, concern had been growing for the past month. A less than impressive bond auction last week hinted that Spanish banks may be reaching the limit at which they can absorb more Spanish sovereign debt (a problem since they've been the only buyers recently). In particular, markets seem to be worried about the sole focus on austerity over growth. Last week’s budget fell squarely into this camp, as did today’s announcement that Spain would find a further €10bn by increasing the efficiency of educational and health spending (these spending areas are controlled by regional governments and as we have noted numerous times, they do not take kindly to having austerity imposed on them and often lack the will or ability to fully implement it).

There is also growing concern about the state of the Spanish banking system – and with good measure given its massive exposure to the bust real estate and construction sectors. Spanish banks’ provisions against losses on this exposure are likely to prove far too small, especially as house prices fall further and economic conditions sour. As the Spanish Central Bank Governor said today:

"If the Spanish economy finally recovers, what has been done will be enough, but if the economy worsens more than expected, it will be necessary to continue increasing and improving capital as necessary in order to have solid entities."

With the recession set to worsen in Spain and much of the eurozone (Spain’s main trading partners), as well as house prices set to fall by possibly another 35%, things look destined to get worse. Just to drive this home the IMIE Index of house prices fell by 11.5% year on year in March – the largest decrease yet.

All in all then, a combination of long-held fears seemingly confirmed by the actions and comments of Spanish state officials and some sour data played a role in setting off the market jitters yesterday. That said, once the fears were put in motion it was always going to be difficult to stop. At some level this is likely to be a correction to the massive post-LTRO optimism seen on European markets, but there are definitely valid concerns underlying it – this is only the beginning of the problems in Spain.

Italy's Reforms: Monti Fires The Starting Gun

Italy's unelected government has entered one of the most delicate stages of its tenure. Mario Monti and Italian Welfare Minister Elsa Fornero (in the picture) have just presented their key proposals for reforming Italy's labour market.

The full text of the draft bill is available here (in Italian). If adopted, the proposed measures would introduce substantial - and desperately needed - reforms to Italy's labour market.

In particular:

• The so-called 'social shock-absorbers' (i.e. unemployment benefits) will be extended to all categories of workers, but will be available for shorter periods to avoid people excessively relying on help from the government instead of seeking another job;

• Apprenticeship will be encouraged as opposed to the current system where too much emphasis is put on academic degrees;

• A proposal to change the peculiar way 'unfair dismissals' are dealt with under Italian law (which we looked at here - basically, anything can count as 'unfair dismissal' which makes it very difficult for employers to hire and fire). But this reform actually seems to have been watered down at the hands of Italy's centre-left Democratic Party, which has close links with trade unions.
  

In addition, Monti also wants to make it more expensive to re-employ temporary workers, by forcing employers to either put temps on a permanent contract or let them go, after a certain period of time. This is a tricky one. Long-term employment should of course be encouraged and the incentives proposed for employers who hire people permanently could help. But would it also not reduce the flexibility of the labour market? And would it actually provide an incentive for firms not to hire permanent workers (instead employing different temporary staff)?

Within Italian context, these are substantial reforms that should not be under-estimated. But they remain somewhat patchy and could be further watered down by the Italian parliament. Being a technocrat doesn't make Monti immune to political pressure - but these reforms, whilst welcome, are only the starting point in the long race to drag Italy out of its current malaise.

Not so bullish now? The short term prospects for Spain inside the eurozone

In a new briefing, Open Europe assesses the state of the Spanish economy in light of recent budget proposals, announced by the Spanish government in full today. Spain is not the “next Greece” - it remains a serious and diverse economy, with relatively good administration and infrastructure. However, the increasing exposure of its banks to potentially toxic loans, the difficulty in curbing Spanish regions' spending and the risk of reforms not taking effect quickly enough, all raise serious questions as to whether the Spanish economy will make it through without some sort of external help.

Key Points

• Given its size, the fate of the Spanish economy will also largely decide the fate of the euro. €80bn of €396bn (1/5) in loans that Spanish banks have made to the bust construction and real estate sectors are considered ‘doubtful’ and potentially toxic, meaning at serious risk of default, with the banks only holding €50bn in reserves to cover potential losses. Already dropping, house prices could potentially fall another 35%, meaning that Spanish banks will almost certainly face hefty losses as more households default on their mortgages.
• In such a scenario, the Spanish state is unlikely to be able to afford to recapitalise its banks, meaning that the eurozone’s permanent bailout fund (the ESM) would have to step in, shifting the cost to eurozone taxpayers.
• As domestic banks are currently the main buyers of Spanish government debt, this could also lead to major funding problems for Spain. The chances of a self-fulfilling bond run on Spanish debt would increase massively in this scenario, threatening to push the whole country into a full bailout.
• Containing spending in the Spanish regions is also key to Spain rebalancing its books. The level of unpaid debt on the balance sheets of local and regional governments has risen by €10bn (38%) since the start of the crisis (now topping €36bn). This will likely be paid off by the central government, increasing the country’s debt and deficit.
• Spain’s various reforms, particularly to the labour market, are welcome, but are themselves not enough to stop a bond run, as it will take time before they bite. The country’s long- term unemployment has now reached 9% of the economically active population, and youth unemployment reached 50.5% last month. This is threatening the long term productivity of the economy and whether Spanish society can sustain this level is unknown.

A Spanish bailout is far from a forgone conclusion, but more work needs to be done to avoid one. Open Europe recommends:

• Spanish banks double their provisions against souring loans and commit to thorough stress tests.
• Strengthen labour market reforms, particularly to relieve the welfare burden on state finances, including: end wage and pension indexation to inflation, reduce size and duration of benefits, limit collective bargaining, reduce redundancy costs and improve the business climate.

However, these reforms will only stand the test of time if they enjoy political buy-in across Spanish society and are seen as democratically legitimate, rather than being imposed from outside.

To read the report in full, please click here,
http://www.openeurope.org.uk/Content/Documents/Pdfs/Spain2012.pdf

The Monti paradox

Over on EUobserver, we take a look at what can be described as the "Monti paradox":

One of the main reasons why the euro crisis has calmed down is Mario Monti – the Italian Prime Minister who replaced Silvio Berlusconi last year, and who now heads a ‘technocratic’ government of professors, economists and former government officials.

But while Monti is pushing through some vital changes in Italy, his lack of a clear mandate from voters could backfire – and spell big problems for the eurozone. There’s clearly a paradox here: Monti took over from Berlusconi (who really was a disaster) following pressure from Berlin and Paris, and runs a government with no directly elected politicians as members.Understandably, this left many worrying about the state of national democracy in Europe. But, at the same time, Monti has so far proven surprisingly popular.

In the polls, his approval ratings have been around 50-60% and he still enjoys strong (but not unconditional) backing in the Italian parliament. That he draws such levels of support should help, as Monti – an economic liberal educated in the US – is intent on driving through some serious structural reform in Italy, finally pushed by markets to do so.

Heaven knows Italy needs it, particularly in the labour market. At the moment, it’s easier to cross the Alps with elephants than to fire someone in Italy, meaning that it’s also extremely costly and cumbersome to hire people. Under the current system, almost anything can count as ‘unfair’ dismissal and judges have huge power to order employers to hire back workers, even for the most trivial reasons. The Italian system goes far beyond other countries with rigorous dismissal procedures, such as France.

For example, one famous case saw an Italian worker, who had called in sick, being filmed while he was taking part in a protest against a trade union leader in Turin (double irony here). Naturally, his boss decided to fire him as, under any reasonable definition, the worker was taking his boss for a ride. However, the worker appealed the case in Court, claiming ‘unfair’ dismissal. The judge sided with the worker and ordered the employer to hire the guy back. His lawyers maintained that the illness he was suffering from prevented him from doing his job but not from engaging in various other activities, including, apparently, protesting in a rally.

Monti is seeking to deal with such abuses by doing what common sense would suggest – radically changing the way ‘unfair dismissals’ are dealt with under Italian law. According to his plan, workers will have to be re-hired only if they have been victim of genuine discrimination (but, in all other cases of ‘unfair dismissal’, workers will still have the right to claim generous compensation).

Monti is also trying to push through a series of other key changes to Italy’s labour market, including making it easier for young workers to be put on permanent contracts and opening up professions such as chemists and notaries.

As is always the case when trying to change entitlement cultures, the road ahead for Monti looks rocky, with Italy’s biggest trade union planning a series of counter-attacks and the centre-left parties pledging to water down the measures in Parliament. And herein lays the risk: Monti has no popular or electoral mandate to fall back on when the going gets tough.

The governments in Spain and the UK are facing strikes and discontent as well, over tough reform measures. But, save coalition complications in Britain, both governments can always point to the mandate that they got from voters in a general election, even when the opinion polls turn against them.

Monti does not have that luxury and already there are signs that support for him is dwindling, as his reforms become better understood. A recent opinion poll showed support down from around 60% to 44% in less than one month, casting doubts as to whether he’ll stay until 2013, the end of his scheduled term.

This begs the question, what happens to his support once the reforms really start to bite, and his lack of a popular mandate really becomes apparent? The risk is that he ends up not only an unelected but also a deeply unpopular Prime Minister that is forced out before the reforms – which must be pushed through with patience and persistence over a number of years – have been completed.

The best scenario would perhaps be for Monti himself to run in the elections in 2013 (or even earlier), to get that clear mandate and get on with business.

Because who would take over from Monti? Support for single political parties in Italy is shrinking, and none of them look able to secure an absolute majority on their own, so we’re looking at another complicated coalition.

A centre-right one is more likely to continue Monti’s work though that is by no means a guarantee, while a centre-left alliance, which might feature smaller left-wing parties, could even reverse Monti’s reforms. If that is the course of democracy, so be it. But there should be no doubt that without the reforms currently being planned, Italy – and its €1.9 trillion debt mountain – will remain a huge liability for the eurozone.

Technocracy may be working in Italy for now, but at the end of the day, there is no replacing the power and conviction that only democratic legitimacy can provide.