European economic outlook

A.BolthoMagdalen College

University of Oxford and Oxford Economics

OXFORD ECONOMICS USA

World Outlook Conference

(Washington, 16 September 2010) (New York, 17 September 2010)

The Outlook for Europe

REVISIONS TO OXFORD ECONOMICS FORECASTS

(GDP; percentage changes)

2010 2011 2012

Euro Zone 1.0 1.6 2.1

U.K. 1.1 2.3 3.0

East. Eur. 1.5 3.7 5.1

Euro Zone 1.5 1.4 1.8U.K. 1.6 2.1 2.7

East. Eur. 1.5 2.4 4.6

Euro Zone 0.5 -0.2 -0.3

U.K. 0.5 -0.2 -0.3

East. Eur. 0 -1.3 -0.5

March 2010

September 2010

Differences

RECESSION AND RECOVERY(GDP; per cent changes; 3 qtrs. mv. avrgs.)

2007 2008 2009 2010 2011 2012 2013

0

2

4

6

-2

-4

-6

UnitedStates

Eurozone

EasternEurope

U.K.

Why has Europe outpaced the US?

• Confidence benefits from fiscal austerity measures?

• Weaker euro

• Dependence on trade

• Depth of downturn

0.8

1.0

1.2

1.4

1.6

1995 1997 1999 2001 2003 2005 2007 2009

70

80

90

100

110

120

130

Source: Haver Analytics

US$/€

Eurozone: Exchange rates1999=100

Effective exchange rate (RHS)

Exchange rate (LHS)

-40

-30

-20

-10

0

10

20

30

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

$ export growth3mma, % year

Source : Oxford Economics/Haver Analytics

US

GermanyEurozone

0

1

2

3

4

5

6

7

8

9

10

US UK Eurozone Germany France

Exports to Emerging Markets% of nominal GDP, 2009

Source : Oxford Economics/Haver Analytics

-40

-30

-20

-10

0

10

20

30

40

50

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10Source: Haver Analytics

3mma, % year

Exports: From Germany

Asia

USUK

Eurozone

RECESSION AND RECOVERY(GDP; levels; 2007 Q1 = 100)

2007 2008 2009 2010

95

97

99

101

103

Eurozone

UnitedKingdom

UnitedStates

Germany

THE MAJOR RISKS

Deficits, debts and fiscal policy

Can Germany save Europe ?

The Euro's longer-run future

PUBLIC SECTOR DEBT(in per cent of GDP)

1999 2001 2003 2005 2007 2009 2011 2013

30

40

50

60

70

80

90

100

Eurozone

UnitedKingdom

BUDGET DEFICITS(General government; in per cent of GDP)

1999 2001 2003 2005 2007 2009 2011 2013

0

-3

-6

-9

-12

Eurozone

UnitedKingdom

OECD COUNTRIES: PUBLIC DEBT AND GROWTH, 1946-2009

5

4

3

2

1

0

-1

Aver. Med. Debt/GDPbelow 30%

Aver. Med. Debt/GDP 30 to 60%

Aver. Med. Debt/GDP 60 to 90%

Aver. Med. Debt/GDP above 90%

Source: C.Reinhart and K.Rogoff, NBER Working Paper No.15639, 2010.

Note: Central government debt only; 20 countries,1186 observations.

GDP growth

CROWDING-OUT

The standard crowding-out effects could be stronger at present because of:

i) The possible presence of a non-linear relation between deficits and interest rates given that all major OECD countries are in debt today

ii) Debt levels could be less sustainable than in the past given that potential growth is almost certainly lower

iii) Rapidly rising deficits raise the danger of monetary accommodation and/or currency depreciation

iv) There are fears of sovereign default, at least in countries such as Greece, Ireland, Portugal and possibly others

EUROZONE - BOND YIELDS AND SHORT-TERM INTEREST RATES

0

2

4

6

1999 2001 2003 2005 2007

Bond yields

Short rates

2009

LONG-TERM INTEREST RATES(bond yields; 3 quarter moving averages)

1999 2001 2003 2005 2007 2009

2.5

3.5

4.5

5.5

Italy

Germany

France

UnitedKingdom

HOUSEHOLDS DEBT/GDP RATIOS

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

50

70

90

110

UnitedStates

Eurozone

U.K.

NON-FINANCIAL CORPORATIONS

DEBT/GDP RATIOS

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

50

70

90

110

130

UnitedStates

Eurozone

U.K.

CHANGES IN CYCLICALLY ADJUSTED BUDGET BALANCES

(in per cent of GDP)

2010 2011 2015 2010 2011 2015 2010 2011 2015 2010 2011 2015

0

1

2

3

-1

-2

-3

Germany France Italy UnitedKingdom

CHANGES IN CYCLICALLY ADJUSTED BUDGET BALANCES

(in per cent of GDP)

2010 2011 2015 2010 2011 2015 2010 2011 2015 2010 2011 2015

0

1

2

3

4

5

6

7

8

Spain Greece Portugal Ireland

FISCAL POLICY SIMULATION

A very simple simulation was carried out on the Oxford Economics global model:

Public expenditure in each OECD country was cut by the equivalent of ½ a percentage point of GDP at the beginning of 2011, 2012 and 2013, so as to achieve a reduction in the budget deficit, ex ante, of 1½ percentage points of GDP by 2013

Interest rates and exchange rates were left to be endogenously determined by the model

FISCAL POLICY SIMULATION

Euro Zone

1.7 1.4 -0.3

U.K. 2.7 2.5 -0.2

Euro Zone

-4.2 -3.2 1.0

U.K. -6.3 -5.4 0.9

2010-13 2010-13Differnc.

Base forc. Simulat.

Effect on GDP growth(average annual percentage changes)

Effect on budget balance*

(in per cent of GDP)

* In 2011-13.

WESTERN EUROPE'S PROSPECTS(GDP; percentage changes)

2009 2010 2011 2012 2013

Eurozone -4.0 1.5 1.4 1.8 2.0

Germany -4.7 3.1 1.8 1.7 2.0

France -2.5 1.5 1.6 2.0 2.1

Italy -5.1 0.8 0.9 1.4 1.4

Spain -3.7 -0.5 0.4 0.9 1.5

U.K. -4.9 1.6 2.1 2.7 3.2

GERMANY - BUSINESS CONFIDENCE AND GDP GROWTH

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

80

85

90

95

100

105

110

0

2

4

-2

-4

-6

ifo index(l.h.scale)

GDP growth (3 qtrs.mv.av. r.h.scale)

4.0

2007 2008 2009 2010 2011

94

96

98

100

102

104

106

Employment

GDP

Employment

GDP

2007-11

2007 2008 2009 2010 2011

94

96

98

100

102

104

106

2007-11

Employment

GDP

GERMANYUNITED STATES

(Indices; 2007 Q1=100) (Indices; 2007 Q1=100)

HOUSEHOLDS DEBT/GDP RATIOS

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

20

40

60

80

100

Italy

FranceGermany

U.K.

Spain

GERMANY - GROWTH IN LENDING

(per cent changes; 3 mnths. mov.avrgs.)

0

3

6

9

12

15

-3

2006 2007 2008 2009

Lending to households

2005

Lending to companies

2010

Eurozonelending to companies

GROWTH IN LENDING TO CORPORATE SECTOR

(per cent changes; 3 mnths. mov.avrgs.)

0

4

8

12

16

20

24

-4

-8

-12

-16

-202006 2007 2008 20092005 2010

UnitedStates

UnitedKingdom

Germany

GERMANY - MANUFACT. ORDERS AND INDUSTRIAL PRODUCTION

(per cent changes; 3 months mov. avrgs.)

0

10

20

30

-10

-20

-30

-40

0

10

20

-10

-20

2006 2007 2008 2009 2010

Foreignorders(t-3)

Domestic orders (t-3)

Industrial product.

FOREIGN TRADE/GDP SHARE(exports and imports of goods and services; constant prices)

0

10

20

30

40

50

60

70

80

90

100

U.K. France Italy Spain Germany

1990 1995 2000 2008 -91 -96 -01 -09

1990 1995 2000 2008 -91 -96 -01 -09

1990 1995 2000 2008 -01 -06 -01 -09

1990 1995 2000 2008 -01 -06 -01 -09

1990 1995 2000 2008 -01 -06 -01 -09

GERMANY - TRADE WITH EASTERN EUROPE*

(percentage shares in total exports plus imports)

1980-81 1985-86 1990-91 1995-96

0

5

10

15

2000-01 2005-06 2008-09

GROWTH OF EARNINGS(1999 Q.1 = 100)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

100

110

120

130

140

Germany

France

Spain

Italy

PRODUCTIVITY GROWTH(GDP per employee; 1999 Q.1 = 100)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

95

100

105

110

Germany

France

Spain

Italy

TOTAL REAL EXCHANGE RATES

(1999 Q.1 = 100)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

80

90

100

110

120

130

140

Germany

France

Spain

Italy

U.K.

Source: IMF.

INTRA EUROZONE REAL EXCHANGE RATES

(1999 Q.1 = 100)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

80

90

100

110

120

130

140

Germany

France

Spain

Italy

Source: EU Commission.

EXPORT PERFORMANCEDifference between growth of exports and growth of markets for goods and services;

volumes, annual averages, 1998-2009

US Japan Germ. Fr. Italy Spn. U.K.

0

-2

-4

REAL WAGE GROWTH(1999 Q.1 = 100)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

95

100

105

110

115

Germany

France

Spain

Italy

CONSUM. PRICE INFLATION(1999 Q.1 = 100)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

100

105

110

115

120

125

130

135

140

Germany

France

Spain

Italy

U.K.

EUROPE - GROWTH OF PRIVATE CONSUMPTION

(2001 Q1 = 100)

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

95

110

125 Spain

U.K.

France

Italy

Germany

EUROPE - GDP LEVELS(1999 Q1 = 100)

1999 2001 2003 2005 2007 2009

100

110

120

130

140

Spain

U.K.France

Italy

Germany

GERMANY - GROWTH AND FOREIGN BALANCE

CONTRIBUTION(three years moving averages)

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

0

1

2

3

4

-1

GDP Growth

Foreign Balance Contribution

Averages 1990-2015:GDP growth 1.5For. bal. contrib. 0.2

GERMAN-"CLUB MED" BOND YIELD DIFFERENTIAL

0

1

2

3

4

5

6

7

8

9

2007 2008 2009

Italy-Germ.

Fr-Germ.

2010

Spain-Germ.

GERMAN-"CLUB MED" BOND YIELD DIFFERENTIAL

0

1

2

3

4

5

6

7

8

9

2007 2008

Greece-Germ.

2009

Ireland- Germ.

Portugal-Germany

2010

THE EURO ISSUE

The immediate problem is one of public sector deficits and debt which are seen as excessive by financial markets (at least in some countries)

But Greece (and other Eurozone members) also face a longer-run low competitiveness problem, generating external deficits

Since financing both domestic and external deficits in these countries has become much more difficult, they must be reduced, but, absent devaluation, this could be very painful

Could EMU fall apart ? Very unlikely given the huge political capital invested

Yet, this is no longer totally impossible

EUROZONE - BUDGET BALANCES

(in % of GDP; annual averages; 2008-10)

Germ. Neth. Italy Spain Grec. Port. Irel.

0

-3

-6

-9

-12

EUROZONE GROSS NATIONAL SAVINGS

(in % of GDP; 2008-10)

Germ. Neth. Italy Spain Grec. Port. Irel.*0

5

10

15

20

25

30

* In per cent of GNP.

EUROZONE CURRENT BALANCES

(in % of GDP; 2008-10)

Germ. Neth. Italy Spain Grec. Port. Irel.

0

3

6

-3

-6

-9

-12

INTRA EUROZONE REAL EXCHANGE RATES

(1999 Q.1 = 100)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

80

90

100

110

120

130

140

Germany

Spain

Italy

Portugal

Netherlands

Ireland

Source: EU Commission.

EXPORT PERFORMANCEDifference between growth of exports and growth of markets for goods and services;

volumes, annual averages, 2004-2009

Germ. Neth. Italy Spain Grec. Port. Irel.

0

2

-2

-4

-6

WHAT'S WRONG WITH THE EUROZONE ?

A simple view:

"The fiscal (policy) rules are good, but ... implementation has been weak"

Jean Pisany-Ferry, FT 17.06.10

A more complicated view:

The fiscal policy rules are a necessary, but not sufficient, condition for a successful monetary union

What else is needed ?

For some, fiscal transfers (i.e. political union)

For others, similar policies for deregulation, the labour market, the welfare state, etc. so as to avoid real exchange rate misalignments

HOW TO LEAVE THE EURO ?

Europe's Monetary Union does not foresee defections. On the other hand, a sovereign country should be able to leave the Union if it so wished

How can it be done ? The issue is not just legally complex, but involves, in particular, some serious financial dangers

Thus, if financial markets were to anticipate that a country wanted to leave EMU, they might well raise bond spreads to levels that would quickly become unsustainable

And if the citizens of that country were to harbour similar expectations, they could, almost costlessly, transfer their liquid balances to banks in other Euro members, leading to what has been called "the mother of all (domestic) banking crises"

Both such events would make exit from the Union both inevitable and ... chaothic !

WHAT WOULD GREECE GAIN BY LEAVING THE MONETARY UNION ?

Monetary independence: Hence lower short-term interest rates (as long as the Central Bank agrees)

Opportunity to devalue the currency

But also: A massive increase in its debt burden (unless debt was redenominated) Almost certainly an increase in inflation and in inflationary expectations

Hence a rapid erosion of any short-run competitiveness gain Hence a likely increase in long-term interest rates

And, in addition, almost certainly, much greater economic instability

This would be very popular with public opinion which overwhelmingly believes that EMU is a burden for the country

It would be less popular with business

The country's new currency would appreciate massively overnight

Companies would be facing significant menu costs as all prices and contracts had to be redefined

Frankfurt would lose importance as an international financial centre relative, in particular, to London

WHAT WOULD GERMANY GAIN BY LEAVING THE MONETARY UNION ?

GROWTH IN THE EUROZONE(per cent changes; 3 years mov. avrgs.)

1999 2001 2003 2005 2007 2009 2011 2013

0

1

2

3

4

5

-1

-2

Periphery*

Core**

* Spain, Greece, Ireland and Portugal.** Germany. Austria, Belgium, Finland and Netherlands

INFLATION IN THE EUROZONE(per cent changes; 3 years mov. avrgs.)

1999 2001 2003 2005 2007 2009 2011 2013

0

1

2

3

4

Periphery*

Core**

* Spain, Greece, Ireland and Portugal.** Germany. Austria, Belgium, Finland and Netherlands