08.07 Weekly Viewpoint : The European Commission has classified as insufficient the measures adopted by Spain and Portugal to cut their excessive deficits

The European Commission has classified as insufficient the measures adopted by Spain and Portugal to cut their excessive deficits, leaving it to the Council to decide whether or not to proceed with sanctions……..

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There is still a margin for reasonable solutions. The June employment report gives positive news for the US recovery, with a strong nonfarm payrolls bounce. The weakness in May was likely transitory. But domestic data are no longer sufficient to move the Fed from its current pause mode. Wait and see is the name of the game.  

-The European Commission announced its decision on the failure of Spain and Portugal to correct their excessive deficits, increasing the chances of sanctions being imposed (initially consisting of a non-interest bearing deposit amounting to up to 0.2% of GDP, but which could evolve into a fine and a suspension of structural funds). The Commission had little margin to act differently, in light of existing budgetary rules. Given the two countries’ electoral cycles, Spain and Portugal have not achieved the planned correction required to cut the deficit/GDP ratio back below the 3% threshold. Spain’s position in particular seems indefensible: despite achieving one of the highest growth rates in the euro area, the country only managed to cut its deficit in 2015 to 5.1%, and the cumulated “fiscal effort” over the past three years has been essentially zero. Portugal’s situation is certainly more reasonable, considering the still modest pace of the economic recovery: the country’s correction effort in 2013 and 2014 was significant, and the deficit unadjusted for the cycle and one-off items decreased in any case in 2015, albeit with an easing of the structural stance. At this point, the Council must decide how to strike a balance between the respect of existing budgetary rules, and allowing sensible political and economic policy conduct. It would be absurd to demand from Portugal a fiscal correction effort that would be unsustainable in both economic (due to slow growth) and political terms (given the precariousness of the government in office). This would create the conditions for a new crisis in an already delicate environment, in the wake of the UK referendum and ahead of the intense elections calendar in 2016-17. On the other hand, it makes sense to require Spain to resume, at a sustained pace, the process of reducing its deficit, although in this case as well fiscal tightening must not compromise the resilience of the recovery, and the reduction of the deficit to less than 3% will have to be postponed. It should also be said that the global economic scenario is burdened with uncertainties, and that overly restrictive budget policies should be avoided in 2017. The choice is a political one, and should be taken by governments rather than by the “technical” European Commission. By the way, the latter hinted that sanctions may well be symbolic.

-The June Employment Report shows strong employment growth after the May disappointment. Non-farm payrolls increased by 287k in June; the revision for the two previous months is -6k. The breakdown by sector is very encouraging, with a recovery in private services (256k from 35k in May), much stronger than the indications provided by the non-manufacturing ISM; payrolls are up in manufacturing (+14 k), flat in construction and down in mining (-6k). Employment in the households’ survey increased by a modest 67k. The workforce bounced by 414k, after dropping sharply in May, with a resulting increase of the participation rate to 62.7%, from 62.6%. The unemployment rate rose back to 4.9%; the broad unemployment rate dropped to 9.6% (low from 04/2008). Work hours grew by 0.2% m/m and point to moderately higher in industrial production in June. Hourly wages confirmed the modest uptrend, with a +0.1% m/m increase. Overall, the data indicate that the slowdown in May employment growth was likely transitory and confirm that slack is still decreasing. The Employment Report sends a positive signal for the continuation of the expansion of the US economy, and eases some of the uncertainty weighing on the domestic scenario, as highlighted by the FOMC in June. However, renewed financial turbulence and the risk of a slowdown in global growth following the UK referendum are reason enough to keep the FOMC on hold in July. It will then remain to be seen if global conditions will allow a move in September: as Fischer and Dudley warned, it will take time to assess the effects of Brexit. The FOMC is now firmly set in wait-and-see mode.

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