With Spanish unemployment topping 27%, it's hard to argue that the recovery is on track. It's not just Spain: the IMF estimates, in its latest World Economic Outlook, that euro-area GDP declined nearly 1% during 2012 and this loss will not be recovered this year.
The Fund forecasts growth of just over 1% during 2014, but based on experience even this feeble figure may be too optimistic. The Fund's initial growth forecast for 2011 was for 1.8%, which turned out to be 0.7%. For 2012, the first forecast was 2.1% compared with an outcome of minus 0.9%.
Unless a substantial part of Europe's unsustainable debt is written off, the dead-weight of the repayment burden will stifle entrepreneurship and leave a generation of demoralised and de-skilled younger workers. Why would anyone invest in Greece or Spain if they believed these countries were going to raise taxes high enough to repay their crippling debt? Sooner or later most of this debt will be written off, and European growth would benefit if it were done now.
The flaccid recovery extends to most advanced countries (Australia being a happy exception so far). In a normal recovery, GDP per head in the advanced economies would by now be around 10% higher than it is (see box 1.1 in the IMF's latest World Economic Outlook). On average, GDP per capita is no higher than before the crisis, with the UK yet to regain its pre-crisis level.
Little by little, recognition is dawning that the contradictory combination of loose monetary policy and tight fiscal policy is not conducive to recovery. Setting policy interest rates at near-zero has not been enough to encourage borrowing and spending in a demand-deficient economy. Quantitative easing (QE) may have given an initial psychological boost, but now financial markets are demanding a continuation of QE bond purchases just to stop traders going into a market-deflating funk. Every new round of QE leaves hostages-for-fortune in future policy-making. It was too much to expect that monetary policy could revive growth single-handed, and pretending that it could has confused the policy process.
In a normal recovery, fiscal policy would be working in tandem with monetary policy. But the aftermath of the 2008 crisis has limited the fiscal room for manoeuvre. After the big boost of 2009, fiscal policy changed tack to focus on deficit reduction as countries attempted to get their debt back on a sustainable trajectory.
Each time the budget deficit is squeezed down another notch, there is a contractionary impact on growth. The graph above from the IMF shows the big hit of fiscal contraction in the European periphery (the green bars) in 2012, with an encore planned for this year. Non-euro advanced economies (blue bar) will have more fiscal contraction this year than last (mainly reflecting the sequester-augmented US fiscal impulse, worth nearly 2% of GDP), with further substantial contraction next year.
With the tensions surrounding the Fund's GDP growth prediction, a realistic forecaster would have to contemplate the possibility, even likelihood, that 'something's got to give.' Austerity is fraying at the edges, with Italy seemingly the latest case. Despite the reduction in deficits — and the painful squeeze involved, shown in the graph — they are still large (over 5% of GDP in the US, 10% in Japan and nearly 7% in Spain) and thus official debt is still rising.
The Fund seems prepared to cut some slack for the UK to ease austerity but there is not much sign of a general departure from the soft monetary/tough fiscal combination.
In advanced economies, the right macroeconomic approach continues to be gradual but sustained fiscal adjustment, built on measures that limit damage to activity, and accommodative monetary policy aimed at supporting internal demand...
The main risks relate to fiscal policies in the United States and, especially, Japan, which are not sustainable. It is therefore disconcerting that the prospects for comprehensive fiscal reform have dimmed in the United States and that policymakers in Japan have renewed fiscal stimulus before adopting a strong medium-term consolidation plan and growth strategy.
Are more radical ideas being explored elsewhere in the Fund? 'Rethinking Macroeconomic Policy', an IMF-hosted conference held in mid-April 2013, posed two key questions for fiscal policy: what is the critical debt level in a world of flighty financial markets and what is the optimal speed of debt reduction? The high-powered seminar didn't, however, offer much in the way of specific answers.
A measure of our ignorance (or the complexity of the issue) is provided by this comparison of the UK and Spain, which have much the same official debt ratio. But Spain's bond interest rate is three times that of the UK and its fragility is far greater. This comparison gives the (British) author the opportunity to repeat the oft-heard English view that the euro was a great mistake. Another (also British) commentator offers a solution: Spain should leave the euro.
Meanwhile, back in the real world, the Fund provides some comfortingly ambiguous words in its G20 Note: 'fiscal tightening must continue at a pace that the recovery can handle'. Indeed.