Strict austerity risks derailing global economic recovery, warns OECD

Larry Elliott, economics editor
guardian.co.uk, Tuesday 22 May 2012 16.06 EDT

http://www.guardian.co.uk/business/2012/may/22/europe-crisis-drag-on-global-economy

Europe's leaders meet on Wednesday for crisis talks to rescue the euro amid a warning from the west's leading economic thinktank that persisting with strict austerity programmes risks a vicious circle that could derail the tentative recovery in the global economy.

Shares rallied on hopes the summit in Brussels will find a solution to the debt crisis by backing proposals from the French president, François Hollande, that will boost growth and create jobs.

But tensions remained between Paris and Berlin, where Angela Merkel's government maintained its strong opposition to the creation of common eurobonds, which would cut the borrowing costs of the heavily indebted countries facing intense financial market pressure.

In London, the FTSE 100 rose by 98 points, reversing part of last week's sharp fall, to close at 5,403 points, a rise of almost 2% on the day. German, French, Spanish and Italian bourses also recorded hefty gains as fears receded of an early departure of Greece from the single currency.

In its half-yearly update on the global economy, the Paris-based Organisation for Economic Co-operation and Development said the 17-nation single currency area was on course to contract by 0.1% this year – with deep contraction in the countries of southern Europe – but said a worsening of the debt crisis could result in output falling by as much as 2%.

The OECD, which has 34 rich-country members, said it expected Greece to contract by 5.3%, Portugal by 3.2%, Spain by 1.6% and Italy by 0.9%.

While pencilling in a return to modest 0.9% growth in 2013, the OECD's chief economist, Pier Carlo Padoan, said: "The risk is increasing of a vicious circle, involving high and rising sovereign indebtedness, weak banking systems, excessive fiscal consolidation and lower growth." Padoan urged Europe's leaders to adopt a "growth compact", which would help countries tackle their budget deficits through faster expansion.

With developing countries such as China still growing strongly, the thinktank said global growth this year would be 3.4%, down from 3.6% in 2011, before rising to 4.2% in 2013.

But growth among OECD members would be held back by Europe and would ease from 1.8% to 1.6% in 2012 before recovering to 2.2% in 2013.

Of the big rich nations, the US and Japan would grow most strongly, while Britain is expected to grow by just 0.5% this year, accelerating to 1.9% in 2013.

"We see a slow rebound of growth in the United States driven mostly by private demand, some pickup in Japan and moderate to strong growth in emerging economies," Padoan said.

"We also see flat growth in the euro area which hides important differences, with northern countries growing and southern countries in recession."

He expressed concern about a debt default in Greece and the shaky condition of Spain's banks, but said the emergency action by the European Central Bank, including a €1tn (£808bn) liquidity injection, had so far prevented the debt crisis from spiralling out of control.

"If the situation gets worse, there are ways to enhance the firewall capacity, which could include a stronger intervention or role of the ECB," Padoan said.

In contrast to the eurozone, the US was expected to continue to benefit from easy credit conditions and ultra-loose monetary policy, with the world's biggest economy forecast to grow 2.4% this year and 2.6% in 2013.

Japan's 2% growth this year would be boosted by a construction boom after the tsunami in 2011, while China would expand by 8.2% in 2012 and 9.3% in 2013.

The OECD predicted the UK would recover this year from its double-dip recession over the winter.

The thinktank maintained its previous 0.5% growth forecast for 2012 while raising its 2013 prediction a notch to 1.9%. "Fiscal consolidation is a drag on growth," it said. "However … fiscal policy remains heavily constrained. The ambitious government plan to restore fiscal sustainability remains on track and appropriate despite disappointing economic growth."

David Cameron's coalition government has lost popularity and come under pressure to change course as austerity measures have hit demand, leading to the UK's second recession in four years, but the OECD said the downturn would be temporary and that after weak growth in the first half of 2012, the economy would then start to pick up speed.

"Growth will remain weak in the first half of 2012, but should gain momentum thereafter, with private consumption supported by higher real incomes, as inflation slows and exports and business investment revive with stronger external demand," the OECD said.

However, the thinktank warned that the economy faced a number of risks. A weaker global economy could hit exports, while global financial turmoil might tighten financial conditions, and higher oil prices would hurt consumption.

Bank withdrawals

Almost 25% of deposits have been withdrawn from Greek banks in the last two years but outflows have been small from other banking systems inside the so-called periphery, according to Barclays analysts.

While Greek deposits are falling, those at Portuguese lenders have risen to record highs, while Spanish and Italian deposits have fallen 3% and 2% respectively. "Talk of a possible exit of Greece from the European monetary union has sparked fears about deposit outflows from other peripheral countries, but these concerns are not new and evidence does not indicate material outflows from Spain, Italy, Ireland, and Portugal," the analysts said.

Even so, fears of a Greek exit from the eurozone have sparked debate about whether there should be an EU-wide guarantee for the single currency area. At the moment, the €100,000 deposit guarantees are paid for by national banking systems – which should prevent the need for any deposits to be withdrawn – but there are suggestions that the cost should be spread across the eurozone.

Barclays analysts said this would not make a difference. "A EU-wide deposit guarantee scheme could be on the agenda in upcoming summit meetings. We believe such a proposal would fail to solve the challenges facing the current European deposit insurance scheme. While it would enhance the creditworthiness of the guarantor, it would still not protect against currency redenomination," the analysts said.

Economist at UBS believe that Greece will remain in the euro because the costs of exit are "excessive" to both Greece and the euro area. Local opinion polls show the majority of Greeks want to remain in the single currency. The UBS economists argue that if Greece considers leaving, the markets and bank depositors will all anticipate the event. "This anticipation of exit would likely result in economic disorder," the UBS analysts said.

"The anticipation, and not the act of leaving, will in all probability lead to the cessation of international trade in the conventional sense, the ability of the government to raise any finance in the markets, and bank runs."

The UBS analysts point out that the concerns are not about the strength of banks themselves. "In the event of a Greek exit, contagion risks clearly exist. There seems to be a great deal of official complacency about the ability of firewalls to prevent this. The risk lies in the contagion of bank runs. Bank runs, if they occur, will likely arise because of existential risks about the euro, rather than solvency or liquidity risks about banking systems," the UBS economists warned. Jill Treanor