• Calm. The wind blowing around the Greek debt problem has abated slightly – for the time being. European finance ministers will not subject the progress they have demanded to a critical review until mid-March and then again in mid-May. By then, it should also be apparent whether Greece can refinance successfully on capital markets. EU policymakers should in any event brace themselves for a possible storm (page 2).

  • Robust. For the time being, therefore, other macro factors can take center stage again. In particular, business sentiment around the globe remained rather robust at the beginning of the year, specifically in industry. This, however, also underscores that the recovery continues to be driven primarily by the temporary, positive effects of the inventory cycle and fiscal stimulus programs.

  • Boost. These impulses are particularly pronounced in the automotive industry, where purchase incentives in many countries are fueling demand. First and foremost in China auto sales surged massively again in January (see chart). The boom in the automotive industry has also seen exports increase strongly again recently, above all in Germany – in the later course of this year, this does, however, harbor considerable potential for a setback (pages 3-5).

  • Brake. And despite the revival of the global economy, investment plans remain muted, above all at small and medium-sized businesses. More difficult access to financing and above all the lack of demand are hurting the domestic demand driven backbone of economic growth in Europe and the US, and, consequently, the upswing as a whole (pages 6-9 and 10-11).

  • Further topics:

    – Data outlook: Ifo continues to point north; US: Strong 4Q GDP to be confirmed (page 12).

    – Market outlook: EUR-USD to remain under pressure; Fed discount rate hike doesn't change our FI outlook (page 23).


Better prepare for the storm

The Greek crisis continues to unfold, and it is an existential crisis for the eurozone, a coming of age test which the eurozone is facing under everybody’s eyes. It is easy to side with the skeptics, with those who argue that we finally have proof that the eurozone cannot work, and sneer at the indecisiveness of European leaders who last week concluded a muchawaited summit with nothing more than a vague commitment in principle to support Greece if really needed.

But perhaps we should instead be looking at them with respect. Eurozone countries embarked on a hugely ambitious and unprecedented experiment ten years ago. They adopted a common currency knowing it would push them towards greater economic and political integration, but not knowing exactly how much integration would be necessary, how much integration would actually materialize, how much integration they really wanted. It was a courageous leap in the dark – perhaps reckless but courageous nonetheless. Now the moment of truth has arrived: the financial crisis has exacerbated the tensions and imbalances accumulated during ten years of monetary union, and brought them almost to the breaking point, requiring corrective action.

There is no doubt that monetary union cannot function without a sufficient degree of fiscal integration. To give credit to the founders of EMU, many of them realized it – this is indeed why they designed the Stability and Growth Pact (SGP). Since national governments were unwilling to relinquish sovereignty, the SGP was meant to constrain national fiscal policies so as to guarantee sufficient coordination and discipline. The problem is that the SGP was never really applied: the letter of the SGP has sometimes been obeyed, but the spirit never has. All the emphasis in the discussions of the SGP has been placed on the 3% of GDP ceiling on the fiscal deficit, and the sanctions that should be applied when a country breaches the ceiling. But the idea of the SGP is that countries should run a fiscal position that is broadly balanced in cyclicallyadjusted terms. In other words, a country should try to keep the budget broadly balanced when growth is running more or less at potential, so that when a recession comes, it can let the automatic stabilizers operate without breaching the 3% ceiling (3 percentage points of GDP having been estimated at the time as the fiscal impact of a large negative shock to growth based on historical experience). Moreover, countries with debt to GDP ratios in excess of 60% should in principle be running even tighter policies, so as to bring the debt ratio down. In reality, however, the SGP has been interpreted as an obligation not to breach the 3% ceiling in good or bad times. As a consequence, many euro-zone countries have been running pro-cyclical, expansionary fiscal policies during the fastgrowth years of the credit boom, instead of taking advantage of the good times to consolidate their fiscal accounts.

Even the letter of the pact has been near impossible to enforce. We tend to forget this now, but during the last recession, the large countries like Germany and France openly violated the fiscal rules, and were not subjected to any sanctions – whereas sanctions were imposed on smaller sinners such as Portugal. That reinforced the idea that the rules were enforced in an arbitrary manner, which depended on the relative political strength of the countries involved, and undermined the credibility and legitimacy of the SGP. Seen from that perspective, it is perhaps less surprising that Greece, not having the same political might as larger countries, was tempted to use some “creative accounting”.

Re-establishing the credibility of the fiscal rules is now essential. Otmar Issing is right to argue that a straightforward bailout of Greece would be “a disaster” for Europe, as it would create moral hazard by rewarding a violation of the rules. If countries came to the conclusion that they can enjoy the domestic political benefits of loose fiscal policy without eventually paying the consequences, fiscal sustainability for the eurozone as a whole would be undermined. The EU is therefore right to insist that Greece take tough adjustment measures. However, we do have to consider the possibility that Greece might not be able to regain the market’s trust quickly enough. And we have to consider that the risks of contagion from a possible sovereign default within the eurozone are potentially large and very difficult to estimate. This is why EU policymakers have indicated they would support Greece if needed. The trick is identifying a way in which the support can be accompanied by credible conditions. The EU has explicitly ruled out an IMF program, indicating it might at most tap the Fund’s technical expertise. That I believe was a mistake. Having gone that route, however, the EU must figure out how to make credible threats to ensure Greece complies with the conditionality – in the event that financial support turns out to be necessary. That will not be easy, and in the policy discussions we can see the desire to somehow circumscribe Greece’s sovereignty in running economic policy. It might be a step in the right direction – a step towards greater centralization of decision-making. It would be a huge step, and not an easy one, especially as it will have to be taken under pressure. Markets seem to have calmed down for the moment, and are observing the negotiations. But this is probably the calm before the storm: as we get closer to the early April redemptions, the market might suddenly lose patience with the slow negotiations and the lack of detail in the EU’s support plans. A decision would then need to be taken very quickly, and EU policymakers had better be prepared.