Ominous signs point to a dangerous year ahead

Fri, Jan 6, 2012, 00:00

Even if mass defaults can be avoided, renewed recession in Europe in 2012 is now as much a likelihood as a probability

PREVIEWING A year is never easy, such is the unpredictability of human affairs. At a time of such chronic uncertainty and rapid change it is almost impossibly difficult. Little can be said with certainty about the 12 months ahead and even less can be taken for granted.

As Europe this week marks the 10th anniversary of the money in citizens’ pocket being redenominated to euro, the biggest question – for Ireland, Europe and the world economy – in 2012 is whether our Continent’s seemingly unending financial/sovereign debt crisis can be contained and resolved.

On balance, and despite everything that has happened and not happened during the two-year-old crisis, one can only continue to believe that Europe’s political leaders and central bankers will be prepared to do much more than they have done to date to prevent meltdown. But that faith is likely to be tested early and often in 2012, with many potential banana skins that, if not avoided, could cause the crisis to slide ever closer to the edge, and very possibly over it.

Italy’s multibillion monthly borrowing needs are an obvious trigger point. In the second half of 2011, investor faith in the world’s seventh-largest economy began to drain away. This augurs ill for 2012.

Although there were some positive signals from the Italian bond market at the end of December, the situation remains fragile. If the trend of the past six months reasserts itself in the new year, Italy will be in serious trouble.

And what happens if a large bond auction fails and the Italian state faces being unable to repay maturing debt?

It is likely that an emergency funding line would be established from the International Monetary Fund. That would buy some time, but it would not amount even to a medium-term solution. Italy is simply too big to be bailed out in the way Ireland has been. The combined resources of the IMF and the European bailout fund would not be adequate to provide it with a three-year package of funding.

With the regional and global impact of Greek default already so painfully obvious, it is difficult to see how the financial system could withstand the utterly unprecedented scale of default that would take place in the event of Italy becoming insolvent. Other near-term risks that could bring the crisis to another level are almost too many to list, but they include the downgrading of the creditworthiness of the remaining triple-A rated euro zone countries, even bigger haircuts on Greek government debt and the possibility that they are imposed rather than being agreed voluntarily, a descent in social chaos in Greece, bank runs somewhere across the Continent, the collapse of the Italian government, and a surprise from Spain in the form of bigger bank losses or a larger than previously admitted to public debt.

If one must believe that leaders will act much more aggressively, if faced with imminent meltdown, there is little reason to believe they will become more proactive in addressing the crisis this year.

More than anything else, that evaluation is arrived at on the basis of how Europe’s most powerful leader has handled the crisis. If anything became clear in 2011, it was how Germany now stands head and shoulders above the rest in the European power stakes. But despite much idiotic evocation of that country’s past aggression, rather than over-exercising its power, Germany has consistently underused it. There is little sign – thus far at least – that the German chancellor Angela Merkel is prepared to take on the responsibilities that come with great power.

Merkel has not spelt out to her electorate how much Germany has benefited from the euro, how culpable the country’s bankers were in creating the entire crisis in the first place and how mass default and the break-up of the euro would vaporise wealth Germans have accumulated over decades.

Merkel’s failure to lead the domestic debate would be far more understandable if significant anti-euro parties, such as exist in Austria, the Netherlands and Finland, were undermining her position. But they aren’t. None of the five parties in the national system has gone populist nor is there any cohesive extra-parliamentary opposition to saving the euro. Given all this, expect plenty more Merkel minimalism in 2012 in confronting the crisis.

It goes without saying that Ireland’s fate this year depends on what happens in the wider international environment. If the apocalyptic scenario of mass default and currency collapse comes to pass, the Irish economy will be at least as badly affected as any other.

But even if that can be avoided, renewed recession in Europe in 2012 is now as much a likelihood as a probability. That would all but extinguish hopes of a recovery in Ireland this year. Exports have been the economy’s only growth engine since 2008 in a period when the domestic economy has contracted almost without interruption. A downturn in foreign markets would, at the very least, cause the export engine to splutter.

Failure to grow, or a renewed contraction in 2012, would not only heap more misery on everyone, it would also sink Ireland’s prospects of exiting the EU-IMF bailout programme.

Continuing to meet bailout targets – on budget deficit limits, bank downsizing and re-entering the bond market toward the end of the year – will be all but impossible without economic growth. If the economy stagnates or contracts in 2012, the Government is likely to have no choice but to seek a second bailout by year’s end.

Among the many other uncertainties in the coming year is whether a referendum will be held on December’s draft treaty containing stronger rules on economic management in the euro area. That treaty is scheduled to be completed by March. Given how little substance there is in the current draft, events may well move so quickly in the new year that a more substantial treaty is needed.

But if a treaty is agreed, the decision on whether to hold a referendum in Ireland will be different from all others in the past in that it will come with immediate cost. The mere announcement of a referendum will almost certainly cause a proportion of the cash deposited in the Irish banking system to be withdrawn. Questions would be raised about whether Ireland’s position in the euro zone would be tenable in the event of a rejection.

If opinion polls pointed to a No vote and there were no assurances from Europe that Ireland’s position in the euro was secure regardless of the outcome of the vote, the risk of a full-scale bank run in the weeks leading up to the poll would arise.

There are likely to be other consequences of December’s decision to draft a new treaty. At this juncture, the treaty will be one among 26 sovereign states, and not an EU treaty. The reason for that is because David Cameron vetoed EU treaty change in Brussels last month, leaving the UK at its most isolated since it joined the European project alongside us four decades ago.

With British popular opinion hostile or indifferent to the EU and a large proportion of the political elite viscerally opposed to membership, the chances of Britain cutting itself loose from Europe and drifting off into the Atlantic are higher than ever. If that happens Ireland will be dragged in two directions and may be forced to do what it has always sought to avoid: make a choice between Britain and Europe.

If prospects for Europe’s economy and union look poor in 2012, there is little cause for great optimism from across the Atlantic.

The US economy remains weak. Like Ireland, it has yet to recover from its property crash, which began in 2006. Nationally, residential property prices are down one-third on the peak and have been treading water for two years.

If the market were to perk up in 2012, it would put a more solid foundation under the recovery, but there is as much reason to believe the property market will continue to stagnate as there is to think it will strengthen – not least the politically paralysing proximity of the presidential election in November.

Another reason not to be optimistic about the US property market, and the economy more generally, is jobs. At the beginning of 2008, 137 million Americans were at work, an all-time record.

Two years later, eight million jobs had disappeared – the biggest labour market shock since the 1930s. In the two years since, employment has risen by just two million, and joblessness remains at historically high levels. A sluggish recovery looks to be about the best outcome the US can hope for.

With the US unlikely to act as an engine of global growth, Europe in the doldrums (at best) and ominous signs of a property crash in China, economically, 2012 looks set to be a year of living dangerously.

FUTURE OF THE EURO ZONE FOUR SCENARIOS

Emerging from crisis and returning to growth:The euro crisis is addressed early in the new year, unleashing pent-up demand in the real economy. The ending of uncertainty causes a strong rebound in sentiment across the Continent and globally. The world economy gets a shot in the arm, with Ireland a leading beneficiary.

Probability in 2012: 10 per cent

Muddling through: EU leaders cannot agree to meaningful action to tackle crisis. Despite this, the many elephant traps that could cause meltdown are avoided. The European economy emerges from soft patch of late 2011 to grow moderately in 2012.

Probability in 2012: 25 per cent

Slipping back into recession and sliding toward the abyss:Same as above, expect the real economy cannot escape the effects of the euro crisis. Europe slides into recession. The absence of growth makes the debt dynamics even worse. The recession and debt crises feed off each other. Despite this, however, meltdown is avoided.

Probability in 2012: 40 per cent

Meltdown: Mass default and break-up of the euro take place. This does not extinguish life on the planet but it does bring the world as we know it to an end.Wealth destruction takes place on an unprecedented scale.

Global depression takes hold. Governments with no funding sources impose austerity beyond anything experienced hitherto.

Probability in 2012: 25 per cent