Asset management

30 April 2012

Economist Insights Holland and Hollande

Policy makers in Europe have recently started to question if the crisis resolution has focused too much on austerity and too little on growth. Less austerity in some countries would result in higher debt levels but it would allow for a smoother adjustment without leading to an unsustainable debt path. Markets understand this. However, until they are convinced of a credible long-term commitment to deliver, they will prefer to see austerity delivered today to promises of future austerity that could be repeatedly pushed into the future. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com
0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 Spa Ire Gre Por Ita Fra Net Fig. 1. Difference in austerity imposed each year between baseline and slower austerity scenario as percent of GDP 2012 2013 2014 0.5 0.0 More austerity

2014
Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

2013 2012

The European prescription for the debt disease has been very Germanic so far two spoonfuls of austerity every budget until symptoms go away. This prescription took a few knocks in the political world last week. First, the government of the Netherlands collapsed after a minority partner quit the ruling coalition in protest over fiscal tightening plans imposed from Brussels. Second, the Socialist candidate Franois Hollande secured the most votes in the first round of the French presidential election. Hollande is arguing for more focus on growth in the Eurozones new fiscal compact. Even Italian Prime Minister Mario Monti, no stranger to austerity, joined in the call for more focus on growth. None of these are landmark changes. The Netherlands ended up scraping together a sufficient coalition to push through enough austerity to meet the 3% deficit target next year. Hollande will find it surprisingly difficult to change the fiscal compact in the face of German dominance and bond vigilante activism. Nonetheless, the political moves do show a growing willingness to challenge the austerity dogma. Could a less austere approach work? The simple arithmetic is that a less austere approach will result in higher debt levels. However, a less rapid programme of austerity does not necessarily lead to an unsustainable debt path. Slower austerity will require a greater total level of austerity to bring debt down, but it gives you time to adjust and has less impact on growth.

2014 2013 2020 2012 2016

4.0 -0.5 3.5 -1.0 3.0 -1.5 2.5 -2.0 2.0 -2.5 1.5 -3.0 1.0 -3.5 0.5 0.0
Spa Ire Gre Por Ita Less austerity Fra Net

2012 2013 2014 Spa Ire Gre Por Ita Fra Net Fig. 2. Difference in level of GDP between low austerity and 2020 2016 baseline scenarios

4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Spa 2016 Ire 2020 Gre Por Ita Fra Net

2020 2016

Source: National Sources, IMF, UBS Global Asset Management

200 Some Eurozone countries are due to tighten their budgets by up to 4% of GDP this year. A less austere approach might 150 be for Eurozone countries to agree to tighten by just % a year every year, but for a longer period of time. A less austere approach can help growth through a higher level 100 of government spending or lower taxation. The European Commission provides estimates of this effect, known as the 50 fiscal multiplier. Using this multiplier, the impact of a slower tightening path can be projected. 2026 2013 2016 2012 2026 2013 2016 2012 2012 2012 2013 0 Spa Baseline Ire Gre Por Ita Fra

Net

In contrast, for Greece and Portugal the argument for slower Low austerity scenario austerity is more convincing. For them, less austerity would IMF Baseline largely be offset by better growth. The peak level of debt would be roughly the same although it would arrive three years later. The difference is that these countries have already undertaken severe austerity moves. Portugals total deficit is already lower than Spain and Ireland, while Greece is getting the benefits of writing off a lot of its debt. If either had tried slower austerity a few years ago debt would have spiralled out of control. Italy is already in primary surplus so debt is already stabilising; much of scenario Low austerityits further effort is to bring debt down faster as a hedge against future growth risks. In France and the IMF Baseline Netherlands you almost wonder what the fuss is about; their current fiscal plans are not much tougher than the slower austerity scenario.

Fig. 3. Peak in debt to GDP ratio and year of peak

Slower austerity secnario 200 150 2012 100 50 0 2012 2013 2016

2026

2026

2013 2016

2012 2012

2012 2013

2014 2015

2012

Spa Baseline

Ire

Gre

Por

Ita

Fra

Net

Slower austerity secnario

Source: National Sources, IMF, UBS Global Asset Management

These scenarios are not forecasts; in truth many other factors would affect the outcome for better or worse. Under more normal circumstances you would expect monetary policy to work to offset fiscal tightening by cutting rates. With monetary policy already close to the zero bound central banks cannot cut rates further, which has led some economists to argue that the multiplier effect could be much larger at the moment. Working the other way, promises of austerity in the future are far less convincing than austerity delivered today. Even if markets understand that slower austerity might be a better solution, they know that if the government today pushes problems into the future, the next government may do the same. Without credibility, interest rates would rise and debt could spiral out of control. Holland has stuck to austerity, but even if Hollande pushes back against quite mild tightening the market will worry that the periphery is next. Fear will trump economics.

Unsurprisingly, the impact is greatest in countries that currently plan the sharpest austerity in coming years Spain and Ireland. Spain is planning tightening of over 4% this year and 2% next year. At a slower pace of tightening the fiscal multipliers suggest the level of GDP could be 3% higher by 2016. The consequence would be that the peak in Spanish debt would arrive fourteen years later and come in at over 100% of GDP. Spain would also need a much greater total level of austerity in order to compensate for building up more debt now. The story is similar in Ireland slower austerity may be better for GDP but will not deal with the debt problem.

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