The Euro-zone economy contracted a less than expected 30bps, quarter-over-quarter, during the 4th quarter of 2011. Relative bright spots were Germany and France. In the former, economic activity declined 20bps, less than the expected 30bps contraction. In the latter, the economy unexpectedly expanded 20bps while consensus estimates indicated it would contract by that amount.
While the Euro-zone economy performed slightly better than expected to close the year, it is likely to contract significantly in 2012. As troubling as that is in its own right, what is more troubling is that official government estimates of deficit and debt reduction are predicated on growth assumptions that bear little resemblance to economic reality. Greece provides an excellent example. The Greek economy contacted 6.8% in 2011. Given the current economic malaise in Europe and additional austerity being imposed upon the Greek nation, its economy is likely to contract dramatically again in 2012 and 2013. Yet official EU and IMF forecasts project a much more modest, although still large, contraction in 2012 of about 3% and, amazingly, a very modest expansion in 2013. The chart below provides the EU/IMF forecasts and those of London-based Capital Economics.
Even if one assumes that the Capital Economics estimates are overly negative, the reality is likely far worse than the EU/IMF estimates. Greece’s unemployment rate is nearly 21%, the economies of its trading partners are weakening, and further austerity measures will be imposed this year. As such, the EU/IMF estimates border on the absurd. Estimates typically incorporate worst, best, and base case scenarios that are probability weighted. Yet the EU/IMF estimates appear to represent a very low probability, best case, scenario.
Across troubled European nations we see much of the same. In Spain, official government estimates for deficit reduction are based on a worst case scenario in which Spanish GDP contracts 50bps this year. Yet even the nation’s central bank expects the economy to contract 1.5%. The nation currently has the highest unemployment rate in the Euro-zone at nearly 23% and its economy contracted 30bps, quarter-over-quarter, in the 4th quarter of 2011. Spain has committed to halving its deficit this year despite the economic challenges in Europe and having significantly missed its deficit reduction goals in 2011. The situation is similar in Italy. The economy contracted 30bps in the 3rd quarter and 70bps in the 4th quarter despite the fact that austerity measures have yet to significantly impact the economy. Still, the Monti government estimates that the nation’s economy is likely to contract only 50bps in 2012. On the other hand, the IMF estimates that the Italian economy will contract 2.2% while the Director of the Bank of Italy told reporters last week that he expects the nation’s economy to contract 1.5% this year. Those estimates seem far more realistic than the official government estimate.
Across the most troubled and indebted nations in Europe governments appear to be basing their deficit and debt reduction goals on highly unlikely economic growth projections. These estimates are overly optimistic at best and purely fanciful at worst. Its seems unlikely that any of the so called PIIGS, with the possible exception of Ireland, will meet their deficit and debt reduction goals in 2012. Not only are they unlikely to meet those goals, but it is highly likely that they will miss them by a wide margin. At best they may make modest progress on debt and deficit reduction. At worst, they are likely to see their balance sheets deteriorate further in 2012. While risk-markets appear to have largely discounted the end of the European debt crisis in recent months, we would caution investors that the crisis is far from over.