The eurozone economy overall will suffer a contraction in 2012. Economic growth was flat year on year in the first quarter, but most indicators suggest a marked deterioration in the second quarter. Even the German economy, which tends to lift the eurozone's overall performance, stalled, growing by only 0.1%. Countries in the periphery, including large ones like Italy and Spain, have been especially weak. Recent published data show that the Italian economy contracted by 0.7% compared with the first quarter.
The downturn is expected to continue into the second half of the year, driven by fiscal austerity, and a lack of credit and deleveraging in the periphery. Core economies are expected to show some resilience, but repeated financial jitters will weigh on business and consumer confidence throughout the euro zone. For the full year our forecast is for slight growth in Germany (0.7%) and France (0.2%). Peripheral economies will suffer deep recessions. We forecast that both Italy and Spain will contract by more than 2%. For the eurozone economy as a whole we forecast a contraction of 0.6%.
The adverse impact of the debt crisis on business and consumer confidence and tight financial conditions in many countries in the region will persist beyond 2012. Fiscal tightening will continue to act as a drag on growth. This will be most marked in stressed peripheral countries (Greece, Portugal, Ireland, Spain and Italy), which are under pressure to reduce their deficits quickly. France is also prioritising fiscal consolidation. Even though Mr Hollande, the newly elected president, had promised increases in public spending, he has now outlined cuts designed to cut the country's budget deficit to 3.5% of GDP in 2013.
The ECB cut its base rate by 25 basis points, to 0.75%, in July in reaction to the declining euro area economy. We expect another 25-basis-point cut at some point in the second half of 2012. This will take the ECB's main policy rate to 0.5%. However, cuts in short term policy rates will have little impact on countries like Spain and Italy, if the cost of borrowing remains at unsustainable levels. In addition to high risk premia in many markets, the need for banks across the euro zone to build capital buffers will restrict credit growth, and highly indebted households in many countries will raise their savings rates, dampening consumption.
The outlook for 2013 and beyond will depend on whether policymakers are able to ease conditions in peripheral funding markets, particularly those of Spain and Italy. Sentiment has improved over the past week following comments made by the president of the European Central Bank (ECB), Mario Draghi, that the ECB was prepared to buy sovereign debt on secondary markets to help reduce the cost of borrowing for governments provided they had applied for euro zone bailout funds.
This could be a game-changer for the euro zone. However, the devil is in the detail. The necessary support from creditor core countries for Mr Draghi's proposals may not be forthcoming. And it remains unclear whether the Spanish and Italian governments will be prepared to apply for bail-outs and subject themselves to conditionality, although their hands could be forced by the markets if borrowing costs remain at unsustainable levels.
Even on the benign assumption that policymakers get on top of the crisis, we expect only an anaemic economic recovery in 2013, with growth of 0.3% for the euro zone as a whole. External conditions will not be favourable, with the US economy sluggish and facing its own fiscal challenges, and growth in China and other large emerging markets much slower than during the boom. Within the eurozone fiscal consolidation will remain a constraint on growth and most peripheral countries are likely to remain in recession. In the event of a break-up of the euro zone, a much deeper contraction would be in prospect. Western Europe would face a depression unprecedented in the post-war era.
We expect growth in the eurozone to pick up gradually from 2014 and to average 1.4% a year in 2014-16. Growth will still be limited by the strictures of the recently signed fiscal compact, which will continue to weigh on government spending. Countries which lost competitiveness during the first decade of the Economic and Monetary Union (EMU) will need to return to sustainable growth through improvements in competitiveness rather than cheap credit. This will take time but will be necessary for the long-term survival of EMU.