GDP Eurozone

Can the Euro survive this situation: The Euro, Greece, Germany and the rest of Europe?

Deflation and weak growth combined with another possible crisis in Greece threaten the existence of the Euro.  This time the economies of southern Europe on not teetering on a collapse, an election in Greece is largest threat to the future of the Eurozone.  A win by the opposition party in late January could trigger a series of actions that put Europe in the position of another bailout or kicking Greece out of the Eurozone.

GDP Growth is waning…..again

GDP growth across the Eurozone has rebounded over the past few years, but it still remains relatively weak (see following chart).  In addition, the low bench mark interest rate of 0.05% set by the European Central Bank (ECB) has done little to boost struggling economies in largely in southern Europe.

GDP Eurozone

Among Eurozone economies, only Ireland and Lithuania, a new member in 2015 are forecast to experience high growth rates this year.  The poor performance of the Iberian Peninsula, Italy, and Greece are continuing to drag down the rest of Europe and put mounting pressure on the currency.  The Eurozone is now on the edge of another recession.  Threats from deflationary pressures and other challenges are only adding to the pessimistic outlook for 2015.

Deflationary pressures are now a reality

Deflation is no longer a threat in the Eurozone but a fact.  Official data released this week, indicated inflation was -0.02% in December compared to the prior months levels and far below the ECBs 2% target.

Energy prices were largely to blame for the deflationary pressure, dropping by 6.3% compared with December 2013 prices.  Excluding energy, prices were up 0.6% in month.

Low inflation rates and deflation make debt repayments more challenging for the already debt burdened countries in the Eurozone, especially Greece, Spain, Italy and Portugal.  With low or declining GDP growth and deflation, the tax bases decline and government revenues along with them.  This makes debt repayment more challenging.

Positively, the likelihood of the ECB taking additional stimulus actions has increased as a result of the December data.  Another round of quantitative easing is likely.   However, Germany, the most influential member of the Eurozone, stands in opposition to additional quantitative easing.

Greek Snap Election Presents Additional Problems

The deflationary pressure has only served to increase an already high debt burden for Greece.  The country has an election on January 25th that could cause a change in the countries leadership.  The liberal left Syriza party joined with the far-right Golden Dawn party to block Stavros Dimas Presidency.  The event triggered an early election.

Reportedly, Syriza is leading by 3% in polls and is backed by many citizens that have not seen improvements in the economy in recent years.   Unemployment remains high in Greece and was 25.7% in November.  The compares to 11.5% for the Eurozone as a whole.

The international finance community and Eurozone members are concern because the Syriza party opposes austerity and would seek to renegotiate the bailout of Greece.   As a result, borrowing costs for the country have already increased to over 10% on Wednesday of this week.     A win by Syriza could trigger actions by the ECB and spell further trouble for the Euro.

Key issue remains unsolved

The actual Euro has been the biggest problem in the Eurozone and bears a good portion of the responsibility for the issues that arose since 2008.  A flood of cheap money after the introduction of the Euro led to an acceleration in economic growth in Greece, Spain, Italy and Portugal as well as in Ireland.  Historically, economists and investors believed these economies were mismanaged to varying degrees. The introduction of the Euro led investors to believe that economic discipline and higher economic growth would follow, at least in part due to the requirements made to be part of the Eurozone.

bond Yields

Money started to flow into these countries and drive down borrow costs.  The preceding chart shows the impacts.  However, when risk levels increased in late 2008, the money supply tightened.  Investors realized higher growth rates had a strong relationship to cheap money that stimulated activities like housing construction, and economic prudence was still lacking.  When investors pulled the money out due to economic concerns, yields skyrocketed.

The Euro and single currency is a factor here because the ECB controls the monetary policy behind the Euro.  Governments in the Eurozone could not independently use monetary policy to stimulate the economy, especially with other powerful players in the Eurozone opposing such measures.  The economic climates then got worse instead of better.

The inability of governments to take actions through monetary policy has hindered growth most of Europe and likely extended the crisis. This is an ongoing issue for the Eurozone and one argument to break it up.

Will the Eurozone survive another Greek crisis?

If Syriza wins, Greece will likely decide that it will not maintain austerity and other measures the key Eurozone members’ support, like deregulation of the labor market.  The ECB and other Eurozone players can either decide to continue to support Greece to maintain the Eurozone or kick Greece of the Eurozone.  The latter would likely cause the Greek economy to endure more hardships, and these troubles could spill into the rest of Europe.

However, following the 2008 crisis and the last Greek bailout, the ECB has addressed this murder/suicide, help us or else, approach by Greece.  Measures were taken to make sure banks and other countries could endure a stress such as this through the much talked about stress tests.  The ECB allowed Banco Espiritu Santo to collapse and Cyprus to default on its debt without much of a sound elsewhere.  A Greek default and collapse would surely make some noise, but would cause nowhere near the damage it could have last time around.

On the other hand, it could bailout Greece again.  If the opposition wins, Greece will most likely initiate more deficit spending.  It would finance the deficit by forcing Greek banks to buy its bonds.  These banks would then in turn sell the bonds to the ECB.  The ECB has to buy them to keep the Eurozone alive and the rest of Europe would again bail out Greece and finance its deficit.  While this violates many agreements, it would keep the Eurozone intact. A bailout could signal other nations, including France, to cease spending cuts and supply side reforms since there are no repercussions.

Northern Europe, the most vocal of which is Germany, opposes another bailout. If they do not allow the ECB to take action, Greece would have to exit the Eurozone putting an end or big hole in the long-time dream of one Europe.  Increasingly, Germany is becoming more comfortable with Greece exiting the Eurozone.    The politics are complicated, and the outcome anything but certain.  Changes in Greece would result in Europe weighing a bailout versus an increasingly tighter European Union.

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