Here we go again

On Monday, Greece exited its third and final bailout programme after eight torturous years.  This is a remarkable moment, but of course it is not the end of the process.  Greece’s real GDP remains down by 25% since Q1 2008, in contrast with the recovery of other crisis-hit European economies.  Unemployment is 20%, and gross public debt is over 180% of GDP.  Greece is now running a primary fiscal surplus of over 3.5% of GDP, but further debt relief may be required – the IMF are doubtful about the ability of Greece to deliver on its ambitious fiscal commitments.

Although the Greek debate largely focused on the nature of the Eurozone and the merits or otherwise of austerity, the underlying issue facing Greece is competitiveness.  Euro membership was not an impediment to the growth process in other fast-recovering small economies.  The more material policy priority is building competitive advantage, as other crisis-hit small countries such as Portugal, Ireland and Estonia have done. 

Greece is structurally unlike other small advanced economies in Europe and elsewhere: its export and FDI shares are relatively low, investment in innovation and human capital is weak, and the quality of the business environment is ordinary (in addition to fiscal imbalances and current account deficit).  Greece needs to become more like other small economies. This will be a long journey. However, even amid the hardship, there are some positive signs: Greek exports are growing, and there is growing foreign investor interest (including from China).

But even as Greece exits the programme, Italy is moving to centre stage.  Italy has many similarities with Greece, in terms of weak policies and institutions, fiscal imbalances (the stock of gross public debt is 130% of GDP), and sluggish GDP growth (1.1% in the year to Q2, 0.2% qoq).

The new Italian government has taken a combative approach to the EU, and there are clear flashpoints with respect to the upcoming budget.  Given the rhetoric, it seems unlikely that much flexibility will be granted by the EU.  Already 10 year government bond yields have spiked up in Italy, from 1.75% in early May to around 3.2% now.  This will create significant fiscal stress, particularly given slow Italian GDP growth.  Italian equity markets are also down by over 12% since early May.

And whereas Greece was a small part of the Eurozone economy, at around 2.5% of Eurozone GDP in nominal terms in 2010, Italy is another matter entirely, accounting for over 15% of Eurozone GDP (about half that of Germany).  It was possible for Mr Draghi to ‘do whatever it takes’ when the problems stemmed from Greece; it is much more challenging when the issues stem from the Eurozone’s 3rd largest economy.

It is possible of course that this is so much posturing, and that eventually the Italian government will revert to a fiscal policy stance consistent with the requirements of Brussels and Frankfurt.  But this should not be taken for granted.  The electoral incentives (and philosophical preferences) of the current government seem to be for conflict.

Which brings us back to Europe’s small economies.  It is instructive that the economies that took the hardest line during the Greek negotiations on fiscal discipline and ‘playing by the rules’ were the Northern bloc of predominantly small economies, from the Nordics to the Netherlands.  This was not just the German approach.  It was the small economies at the top of Europe that had a sharp, coherent view on what was required for a small economy to recover from the crisis and to prosper.  A similar policy stance can be expected in the event of an Italian crisis.

Indeed, an important development over the past year has been the establishment of the so-called ‘Hanseatic League 2.0’, an informal grouping of eight small economies (the Netherlands, Ireland, Denmark, Estonia, Finland, Latvia, Lithuania and Sweden) to support liberal, open approaches to European economic and monetary union.  Increasingly, it is this group of economies that are making the intellectual running in Europe.  Not all of these economies are euro members, notably Denmark and Sweden, but they share a common outlook on European integration and domestic policy approaches.  The perspectives of this group will play a key role in any crisis, and are at the core of a hard Europe.

In terms of the economic fundamentals, I am broadly positive on the economic outlook for Europe. Although some of the larger European economies have taken a step backwards over the past several months, there is ongoing economic momentum and strength in several small European economies.  But political and institutional risks are growing, notably from Italy, which will further weigh on the euro as well as on the economic performance of at least parts of the European economy.  And the potential for more disruptive or existential threats to the Eurozone should be taken seriously: it is possible to see an Italian-led crisis leading to a reconfigured Eurozone in a way that was not the case with Greece.

There are also political tests elsewhere in Europe, as the Brexit process moves closer to the Article 50 deadline, as Swedish elections are held in September (with the anti-immigration and Eurosceptic Swedish Democrats polling well), as well as tensions with countries like Poland and Hungary.  After the political and market relief of the electoral victories of Mr Macron and Mr Rutte last year – in which the euro rallied from around 1.05 to 1.25 against the USD – politics is moving back to centre stage in Europe.  Prepare for turbulence.

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