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Europe in 2012: Renaissance or More Dark Ages? Print E-mail
Long Term Forecasts | Written by Wells Fargo Securities | Dec 20 11 10:20 GMT

Europe in 2012: Renaissance or More Dark Ages?

Executive Summary

According to the popular narrative, the European sovereign debt crisis was caused by runaway government spending in peripheral European countries. However, this narrative is somewhat of an oversimplification. Although Greece, Portugal and Italy all entered the current crisis with budget deficits and elevated debt-to-GDP ratios, Spain and Ireland had exemplary fiscal records. These economies were instead felled by burst housing bubbles. The capital inflows that contributed to the housing bubbles in Spain and Ireland led to real exchange rate appreciation, which caused a loss of price competitiveness. Greece, Portugal and Italy also experienced a loss of competitiveness that will have important implications for growth prospects in those countries in the future.

European leaders have essentially diagnosed the problem facing all of the Eurozone as one of fiscal indiscipline in some wayward countries and have prescribed a remedy of harsh fiscal medicine as a way to regain economic health. We readily acknowledge that governments need to balance their budgets over the economic cycle, but we believe that excessive focus on deficit reduction at this point in the cycle could be counterproductive for many economies in the euro area.

Economic growth is a crucial ingredient for many countries to stabilize their debt-to-GDP ratios. This is especially true for Italy, which has nearly €2 trillion in outstanding government debt. With Italy unable to devalue its currency, with the European Central Bank (ECB) limited in its ability to cut interest rates further and with fiscal tightening in train, Italy has dim growth prospects over the next few years. The effective way that the Italian economy can grow is to enact labor market reforms that will raise productivity growth and restore lost price competitiveness. However, it will take years for the reforms to bear fruit, and financial markets may run out of patience well before then. In our view, the ECB will ultimately need to offer unlimited support to the Italian bond market to prevent a generalized financial crisis.

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Wells Fargo Securities

Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A, Wells Fargo Advisors, LLC, and Wells Fargo Securities International Limited. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company © 2010 Wells Fargo Securities, LLC.

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