This is an extended version of the article that appeared in the December 2012 issue of Investment Advisor.
The eurozone and its politicians continue to face many unresolved and highly important issues. This makes the path ahead rocky and volatile. But important structural improvements have already been made. If—and it's a big if—the international environment remains fairly benign, 2013 could be the year Europe moves on.
Good news has been scarce in Europe during 2012, but next year could prove a turning point. It has been a very tough year from a fiscal retrenchment perspective and the impact this has had on growth and the real economy. Despite the hurdles still ahead, a shift toward recognizing the need to promote growth bodes well for next year. What is particularly encouraging is that 2012 could represent the "peak" year for austerity in the eurozone.
Over the last two years, big fiscal adjustments have been made: The average primary budget deficit for Greece, Italy, Ireland, Portugal and Spain fell from 9.4% of GDP to 1.6% of GDP. Meanwhile, according to Deutsche Bank, the aggregate euro area fiscal deficit fell from 6.5% of GDP in 2009 to 4.2% in 2011 and should fall again to 3.2% this year.
There is now a change of tone among leaders and economists. Politicians are showing signs of a slight shift in stance toward measures that promote growth without undermining the important progress of the last two years. In a report in mid-October, Deutsche Bank estimates that in absolute terms, the fiscal stance in the region will tighten in 2013, but the pace of discretionary fiscal consolidation will slow.
The IMF has been especially vocal in its warnings against cutting too far and too fast—a distinct change from previous messages. As the same report argues, a more subtle change is occurring in that leaders are recognizing that it is more important to reduce the structural deficit than the headline deficit. This is important as the need to make long-term changes to adjust to a more sustainable economic model is as important as ever, but austerity that chokes growth is self-defeating.
The change has not just been in political rhetoric. For example, in Portugal, the troika—the IMF, the EU and the European Central Bank (ECB)— recently increased the program deficit targets to allow automatic fiscal multipliers to run more freely, letting the cyclical deficit rise and avoiding piling austerity on austerity which, while reducing the headline deficit, may do more harm than good.
This is not happening everywhere. The French budget announced in September shows that not all governments have grasped the need to find growth-enhancing structural reforms. With plans to fill two-thirds of the 30 billion euro gap through tax increases, French President Francois Hollande has reneged on his election proposal to focus on growth instead of austerity. The plan especially targets the large corporate sector, which will hinder companies in regaining confidence and creating badly needed jobs. What's more, by hitting a broad section of society, the policies risk being socially as well as economically unsustainable.
There are, therefore, exceptions. Because of a time lag, many of the austerity measures introduced this year will start to bite in 2013. But overall, 2013 could mark a turning point. An escalation in the social unrest witnessed this year across peripheral Europe is one of the key risks facing the eurozone: How much austerity populations will take before governments and their reform programs are cast aside is a big unknown. A softer position on austerity across the continent will likely be a force for social stability as well as economic growth.
Of course, the eurozone will only begin the long road to recovery next year if the international economic environment allows it. The good news is that the world's two largest economies are showing encouraging signs.
