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Predictions for 2012 and beyond
I put forward five ‘benchmark’ scenarios of what I believe could happen, listed in order of likelihood. (By ‘benchmark’ I mean two things. First, I exclude unpredictable, but far from implausible, ‘tail risks’, such as major oil price shocks as a result of the looming conflict in the Middle East. More importantly, these are stylised developments. Although each one is broadly internally coherent, there is of course scope for intermediate scenarios.)
Scenario 1: Economic policy in the euro area continues as at present, but the economic situation worsens drastically, with the contraction in the periphery accelerating and recession spreading into the core. Fiscal ratios start to spiral out of control again. Unemployment rises. Protests grow in intensity. Faced with the deepening crisis and the likelihood of a major catastrophe there is finally a change of heart by existing policymakers or they’re replaced by disaffected electorates. Decisive policies are implemented that address the trinity of challenges and slowly start to resolve the crisis.
Economic and labour market outcomes in 2012 would be dismal, especially in the periphery. But a recovery would set in during 2013. The euro area would remain intact and policy changes would lead to an increase in the degree of policy integration between the euro area countries, including the setting up of new institutions, and not just ‘coordinated austerity’. I consider this “death-bed-conversion” scenario to be the most likely. If I had to put a number on it, I would say about 50:50.
Scenario 2: Some small adjustments are made to economic policy in Europe–e.g. additional ECB interventions in debt markets, some relaxation of austerity, helped by a benign global environment – that, all together, do just enough to avoid a break up of the euro area. The area remains intact but the economy stagnates, unemployment and fiscal burdens rise further in most countries. 2012 ends not much different from 2011, but the pessimism is deeper and welfare states weaker. Call this the “bad-dream-continues” scenario. I would give this more pessimistic scenario a probability of around one in three.
Scenario 3: Economic policy in the euro area continues as at present, but the economic situation worsens seriously, with the contraction in the periphery accelerating and recession spreading into the core. Fiscal ratios start to spiral out of control again. Unemployment rises. Protests grow in intensity (so far as in S1). However, policy still stubbornly fails to change course. Some countries (Greece, Italy) are forced out of the monetary union and the euro area breaks up. There are massive defaults on both public and private debt. The economy implodes due to the continued overlaps between the finances and economics of the countries. There is widespread economic, social and political devastation in Europe and a worldwide recession. This is simply the worst-case scenario: It requires a degree of obtuseness on the part of policymakers that, even after the experience of the least two years, I still cannot imagine. But stuff happens: think of the First World War. Estimated probability: 10 per cent.
Scenario 4: Economic policy in the euro area continues as at present. The economic situation worsens seriously in the periphery, but not in the core countries, where growth resumes as consumers and investors become more confident about successful fiscal consolidation. One or more of the peripheral countries is forced out of the euro area. Their populations suffer in the short run, but, freed of the euro, bounce back quickly thanks to the beneficial effects of depreciation. Freed of the dissolute members, the core countries have no difficulty maintaining a currency union broadly as envisaged in Maastricht plus enhanced fiscal surveillance. This is a sort of Hans Werner Sinn meets Paul Krugman scenario. Its probability is hard to judge.
I think a limited and orderly exclusion of some members with the recreation of a latter-day D-mark bloc is a pipedream held by many on the European right and a much smaller number on the (particularly American) left. No peripheral government will volunteer for this course, because the short-run economic and political risks and costs are so great. But they could be forced out by a suspension of external support, and the process could be swift. It’s possible, but I think unlikely because most policymakers share my view that the associated dislocation would be huge (actually not much better than in S3). Devaluation is no panacea, threatening rapid inflation. For the sake of argument I will give this a probability of 5 per cent. That leaves:
Scenario 5: European policymakers experience some sort of epiphany, or there is a change in leadership in the near future that leads to a change of course along the lines recommended above. In the absence of further problems substantially worsening the economic situation further crisis should be avoided. By the end of 2012, Europe’s core is leading an emergence and the periphery is hot on the tail. Growth subsequently pick up, as pent up demand is satisfied; unemployment and deficits begin to fall.
Such a policy change is what I, and many others, have been arguing for throughout the past two years. It is economically eminently feasible. All actors would be better off. But from all we have learnt in the crisis – and given the considerations above – the probability of this “progressive-pipe-dream” scenario occurring in 2012 is – do the maths – very close to zero.