Despite the changing political complexion of Europe due to recent elections, the austerity drive of recent months is unlikely to be significantly deflected, argues Brian Lawson of Exclusive Analysis.

Editor's note: Below is an overview of the eurozone and its problems by Brian Lawson, who is global chief economist at Exclusive Analysis, a firm providing information and analysis about geopolitical and other important issues. While this publication does not necessarily share the views expressed here, it is grateful to Exclusive Analysis for permission to carry this article. 

The election of President [Francois] Hollande in France has been widely presented as a break with the "Merkozy" axis that emphasised debt reduction and fiscal rigour as the primary solution to the eurozone´s deep-rooted problems. The March 2012 Treaty on Stability, Coordination and Governance (commonly known as the fiscal compact) is ambitious and unlikely to be implemented fully. 

The fiscal compact requires a budget deficit of 3 per cent of gross domestic product or less in 2013 and aims for medium-term balanced budgets with annual deficits below 0.5 per cent of GDP. It also limits the debt to GDP ratio to 60 per cent or requires an annual reduction of this debt by 1/20th per year. Offending countries could be fined 0.1 per cent of GDP, thus deepening the fiscal challenges that they are facing. The fiscal compact looks too ambitious and punitive to have any realistic chance of being implemented.

The historical evidence shows poor commitment to similar eurozone fiscal constraints in the past by virtually all member states.

Looking at the ten-year period from 2002 to 2011 only Estonia, Slovenia, Slovakia, Luxembourg and Finland met the 60 per cent debt target throughout, with twelve of 17 eurozone members breaching this goal at some stage. Similarly, only three countries have met the 3 per cent of GDP budget deficit target consistently. Germany may feel confident about the decline in its deficit in 2011 from 4.3 per cent to 1 per cent of GDP in 2010, but its deficit exceeded the 3 per cent of GDP benchmark for six of the past ten years. Moreover, Germany’s debt stock was over 60 per cent throughout the period, ending 2011 at 81.2 per cent. 

France, the Netherlands, Finland and Austria have had no significantly better performance than the countries at the heart of the eurozone crisis. One of those, Ireland met both targets consistently until the failure of its banking system, breaching the 3 per cent deficit goal from 2008 and the 60 per cent debt stock goal in 2009. But its 31.2 per cent deficit in 2010, to bail out its banks, is now the highest recorded, and its 13.1 per cent deficit in 2011 was the highest in Europe. Unsurprisingly, Greece never met any of the targets, as well as filing dishonest and incorrect data on a consistent basis. Its debt stock was never below 97.4 per cent and it reached 165.3 per cent in 2011 prior to default.

If IMF growth forecasts are right, history will repeat itself and despite the focus on austerity, the eurozone will not meet the fiscal deficit targets agreed in the fiscal compact.

IMF forecasts show the eurozone as a whole just meeting its 3 per cent fiscal deficit goal, but France and Spain are well above this ceiling, and neither country is undertaking the required reduction in its debt stock by 1/20^th. Instead, in 2013, both France and Spain are projected to increase their ratios of total debt to GDP as most countries did between 2010 and 2011. Spain, Italy, France and the eurozone as a whole are also all heading in the opposite direction from the goals set out in the Treaty with rising ratios of outstanding debt to GDP.

The technical evidence supports the forecasts that the eurozone is unlikely to be able to deliver the fiscal compact which is instead leading to a decline in growth and, therefore, fiscal revenue across the eurozone.

On 4 April, an interview with Lagarde challenged the EU orthodoxy: "If everybody goes at the same pace with austerity measures, it puts the whole region at risk…We also need a proper balance between the austerity measures that are necessary and the growth-facilitating measures. So, obviously, it’s not a one-size-fits-all." This supports IMF research that highlights scenarios where the initial impact of fiscal cuts may appear contradictory because they lead to a fall in GDP and produce a negative impact on tax receipts and social security spending. In particular, the IMF argues that the negative impact of a fiscal tightening is greater in recession, and spreading cuts over two years rather than a single annual period can mitigate damage significantly.

Despite the weaknesses of the fiscal compact, governments have remained committed to implementing it. A key indicator of political support will be whether Hollande manages to lead a coalition of governments that are able to dampen down the fiscal compact.

The fiscal compact looks likely to come into force as it requires 12 of the 17 countries to approve it. Greece, Portugal and Slovenia have already signed up, with Ireland holding a referendum on 31 May. Spain introduced constitutional measures in 2011 for deficit reduction, supported by both PSOE and PP, making approval highly likely there. Only two EU members have opted out (the UK and the Czech Republic). And as we will see below, France has pledged to renegotiate it.

Governments have continued to squeeze themselves ever harder to meet the demands of austerity and the compact despite the fact that their voters and supporters are objecting, including in civil unrest as in Portugal, Italy and Greece. In Italy, the government announced additional austerity measures to cut the budget by €4.2 billion (around $5.39 billion) in 2012 as the projected decline for 2012 increased from -0.4 per cent to -1.2 per cent. In Spain, following the €27 billion of savings through higher taxes and spending cuts announced in the 2012 budget, the government is seeking similar savings in 2013. Even in the Netherlands, where Geert Wilders' Freedom Party withdrew support for the government's efforts to meet a 3 per cent of GDP budget deficit target by end 2013 and forced the government to resign, a pro-Euro cross-party agreement has passed the necessary salary freezes and VAT tax increases. In late April, the Czech Republic also held a vote of confidence over austerity, although in this case the government survived.

However, during the same month as part of the French election campaign, the socialist candidate Hollande proposed a renegotiation of the European Treaty to provide for more growth, provoking a strong and hostile reaction from Merkel, and highlighting the potential breakdown of the prior Merkel-Sarkozy pact. Hollande is likely to find an ally in Italy’s Mario Monti who has suggested a provision to allow budget deficits for investment but not current expenditure.

We do not see any substantial shift in policy arising from what Hollande proposes. He has committed France itself to the policy prescriptions of the fiscal compact by pledging to reduce the deficit to 3 per cent by 2013 and to balance the budget by 2017. From comments already made, Hollande will likely advocate measures such as increasing the role of the European Investment Bank, the introduction of specifically dedicated Eurobonds to finance infrastructure projects and an increase or more efficient use of European structural funds.

None of these developments change the substance of the austerity drive in the fiscal compact. Merkel will likely negotiate a quid-pro-quo for supporting them, but is unlikely to agree to renegotiate the fiscal compact as such, while at the same time blaming others, or the decision-making in the EU and eurozone, for not being able to implement all of the proposals.