A Few Thoughts on the EU Recommendations

As widely tipped, the EU is recommending giving several countries more time to reach the budget deficit targets.   We have long argued that moving the goal posts was and remains the most likely course. 

EC President Barroso insisted that this is not a retreat from the austerity, but rather "because of the good progress made, we now have the space to slow down the pace of consolidation."

That narrative is not compelling. It is not a change in economics that is dictating the change in tact but politics.   Youth unemployment in the euro area is nearing 25%, with updated figures due at the end of the week. Even if they are not very organized, the populism on the right and left threatens the elites. German politics are also a key consideration as polls that despite Merkel's popularity, she might not be able to secure a majority for her governing coalition. Softening austerity and seeking modest stimulative measures may curry support from some voter and steal some of the critics thunder, but not too much to alienate the center-right base.

The EU recommendations have to be approved by the finance ministers, but with Germany's Schaeuble on board, there is unlikely to be much opposition. That the Dutch are given until 2014, France 2015 and Spain 2016 to reach the 3% deficit/GDP target was anticipated. That Portugal and Slovenia were given until 2015 was not as anticipated. Poland was given an extra year as well (2015)).

Separately, it was recommended that Italy and Hungary be allowed to exit the excessive deficit procedures. The former was widely tipped. The latter, less so. Latvia, Lithuania and Romania also should exit the excessive deficit procedures, the EU recommended. 

Slovenia, which is seen by many as the next likely candidate for assistance, received more time to reach its deficit target, but came under broader pressure to have an independent review of its banking system, implement structural reforms and take measures to encourage direct investment inflows.

Barroso wants countries to use the "grace period" to take the structural reforms necessary to boost competitiveness. This of course is easier said than done. What needs to be done seems clear. We think that World Bank's Doing Business studies offer insight into low hanging fruit to bolster entrepreneurial activity, from easing the procedures and costs to start a business, register property, through closing businesses. The problem, at the risk of over simplifying, political in nature--the balance of power between rent seekers and profit-seekers.

The tensions between France and Germany continue bubble just below the surface. The BBK's Weidmann seemed to resist the idea that France be given more time, tough it is the finance ministries' call, not central bankers. However, Weidmann's sense that France is not setting the example it should, seems to be more widely shared--not only by the North, but also by the periphery, who wish France would articulate their interests more.

The EU compromised. It gave France two more years (though the Hollande government says it only asked for one), but also called France to task. It urged France to cut public spending to address the structural deficit and simplify its tax system, lower labor costs (which others in the periphery have done primarily by cutting government workers wages and/or pensions rather than private sector measures), and increase the competition in the service sector.