By Xavier Timbeau

This text summarizes the OFCE’s October 2012 forecasts.

The year 2012 is ending, with hopes for an end to the crisis disappointed. After a year marked by recession, the euro zone will go through another catastrophic year in 2013 (a -0.1% decline in GDP in 2013, after -0.5% in 2012, according to our forecasts – see the table). The UK is no exception to this trend, as it plunges deeper into crisis (-0.4% in 2012, 0.3% in 2013). In addition to the figures for economic growth, unemployment trends are another reminder of the gravity of the situation. With the exception of Germany and a few other developed countries, the Western economies have been hit by high unemployment that is persisting or, in the euro zone, even rising (the unemployment rate will reach 12% in the euro zone in 2013, up from 11.2% in the second quarter of 2012). This persistent unemployment is leading to a worsening situation for those who have lost their jobs, as some fall into the ranks of the long-term unemployed and face the exhaustion of their rights to compensation. Although the United States is experiencing more favourable economic growth than in the euro zone, its labour market clearly illustrates that the US economy is mired in the Great Recession.

Was this disaster, with the euro zone at its epicentre, an unforeseeable event? Is it some fatality that we have no choice but to accept, with no alternative but to bear the consequences? No – the return to recession in fact stems from a misdiagnosis and the inability of Europe’s institutions to respond quickly to the dynamics of the crisis. This new downturn is the result of massive, exaggerated austerity policies whose impacts have been underestimated. The determination to urgently rebalance the public finances and restore the credibility of the euro zone’s economic management, regardless of the cost, has led to its opposite. To get out of this rut ​​will require reversing Europe’s economic policy.

The difficulty posed by the current situation originates in widening public deficits and swelling public debts, which reached record levels in 2012. Keep in mind, however, that the deficits and public debts were not the cause of the crisis of 2008-2009, but its consequence. To stop the recessionary spiral of 2008-2009, governments allowed the automatic stabilizers to work; they implemented stimulus plans, took steps to rescue the financial sector and socialized part of the private debt that threatened to destabilize the entire global financial system. This is what caused the deficits. The decision to socialize the problem reflected an effort to put a stop to the freefall.

The return to recession thus grew out of the difficulty of dealing with the socialization of private debt. Indeed, in the euro zone, each country is forced to deal with financing its deficit without control of its currency. The result is immediate: a beauty contest based on who has the most rigorous public finances is taking place between the euro zone countries. Each European economic agent is, with reason, seeking the most reliable support for its assets and is finding Germany’s public debt to hold the greatest attraction. Other countries are therefore threatened in the long-term or even immediately by the drying up of their market financing. To attract capital, they must accept higher interest rates and urgently purge their public finances. But they are chasing after a sustainability that is disappearing with the recession when they seek to obtain this by means of austerity.

For countries that have control of their monetary policy, such as the United States or the United Kingdom, the situation is different. There the national savings is exposed to a currency risk if it attempts to flee to other countries. In addition, the central bank acts as the lender of last resort. Inflation could ensue, but default on the debt is unthinkable. In contrast, in the euro zone default becomes a real possibility, and the only short-term shelter is Germany, because it will be the last country to collapse. But it too will inevitably collapse if all its partners collapse.

The solution to the crisis of 2008-2009 was therefore to socialize the private debts that had become unsustainable after the speculative bubbles burst. As for what follows, the solution is then to absorb these now public debts without causing the kind of panic that we were able to contain in the summer of 2009. Two conditions are necessary. The first condition is to provide a guarantee that there will be no default on any public debt, neither partial nor complete. This guarantee can be given in the euro zone only by some form of pooling the public debt. The mechanism announced by the ECB in September 2012, the Outright Monetary Transaction (OMT), makes it possible to envisage this kind of pooling. There is, however, a possible contradiction. In effect this mechanism conditions the purchase of debt securities (and thus pooling them through the balance sheet of the ECB) on acceptance of a fiscal consolidation plan. But Spain, which needs this mechanism in order to escape the pressure of the markets, does not want to enter the OMT on just any conditions. Relief from the pressure of the markets is only worthwhile if it makes it possible to break out of the vicious circle of austerity.

The lack of preparation of Europe’s institutions for a financial crisis has been compounded by an error in understanding the way its economies function. At the heart of this error is an incorrect assessment of the value of the multipliers used to measure the impact of fiscal consolidation policies on economic activity. By underestimating the fiscal multipliers, Europe’s governments thought they could rapidly and safely re-balance their public finances through quick, violent austerity measures. Influenced by an extensive economic literature that even suggests that austerity could be a source of economic growth, they engaged in a program of unprecedented fiscal restraint.

Today, however, as is illustrated by the dramatic revisions by the IMF and the European Commission, the fiscal multipliers are much larger, since the economies are experiencing situations of prolonged involuntary unemployment. A variety of empirical evidence is converging to show this, from an analysis of the forecast errors to the calculation of the multipliers from the performances recorded in 2011 and estimated for 2012 (see the full text of our October 2012 forecast). We therefore believe that the multiplier for the euro zone as a whole in 2012 is 1.6, which is comparable to the assessments for the United States and the United Kingdom.

Thus, the second condition for the recovery of the public finances is a realistic estimate of the multiplier effect. Higher multipliers mean a greater impact of fiscal restraint on the public finances and, consequently, a lower impact on deficit reduction. It is this bad combination that is the source of the austerity-fuelled debacle that is undermining any prospect of re-balancing the public finances. Spain once again perfectly illustrates where taking this relentless logic to absurd lengths leads: an economy where a quarter of the population is unemployed, and which is now risking political and social disintegration.

But the existence of this high multiplier also shows how to break austerity’s vicious circle. Instead of trying to reduce the public deficit quickly and at any cost, what is needed is to let the economy get back to a state where the multipliers are lower and have regained their usual configuration. The point therefore is to postpone the fiscal adjustment to a time when unemployment has fallen significantly so that fiscal restraint can have the impact that it should.

Delaying the adjustment assumes that the market pressure has been contained by a central bank that provides the necessary guarantees for the public debt. It also assumes that the interest rate on the debt is as low as possible so as to ensure the participation of the stakeholders who ultimately will benefit from sustainable public finances. It also implies that in the euro zone the pooling of the sovereign debt is associated with some form of control over the long-term sustainability of the public finances of each Member State, i.e. a partial abandonment of national sovereignty that in any case has become inoperative, in favour of a supranational sovereignty which alone is able to generate the new manoeuvring room that will make it possible to end the crisis.

By Jean-Luc Gaffard

The luxury industry has been spared the spreading crisis, which in the media’s eyes seems to be posing a paradox. This situation in fact corroborates the diagnosis that rising inequality is the true breeding ground of the crisis.

LVMH, the global leader in the luxury sector, saw its sales jump 26% in the first half of 2012. Richemont, the global number two and owner of such brands as Cartier, Montblanc, Van Cleef & Arpels and Jaeger-LeCoultre, saw its operating income increase by 20% during the second half-year ending 30^th September. The Italian firm Prada announced a 36.5% increase in its turnover in the first half of 2012 (37.3% in Europe). The luxury division of PPR, the other French company in the sector, saw sales go up by 30.7% in the first half year.

These results contrast sharply with the situation in other industries. They are the result of a rise in prices that is nothing less than staggering. The price index for luxury goods as calculated since 1976 (the “Forbes Cost of Living Extremely Well”) rose 800% in 35 years, compared with 300% for the price index for consumer goods.

In an article on the subject (“The more expensive the product, the more desirable”, 8 August 2012), Le Monde reported that the price of a Burberry gabardine raincoat has multiplied by 5.6 and that the price of a Rolex YachtMaster has rocketed from 5,488 to 39,100 euros. These soaring prices simply reflect the great and growing willingness to pay of the richest strata, for whom price is simply a mark of differentiation and desirability.

In these circumstances, the stock market success of companies in the luxury industry is hardly surprising. Nor is it surprising to see the stock market success of companies at the other end of the spectrum, those that produce low-end, cheap goods. This effect, called the hourglass effect, is starkly revealing of the reality of the crisis, which is clearly rooted in widening inequalities in income and wealth.

The healthy state of luxury firms, which are creating jobs at a time of rising unemployment, is obviously a source for rejoicing. But if we simply left things at this remark about the sector, we would be missing the essential point. First, it must be recognized that the industries in question are responding to higher demand much more by raising prices, and not the quantities produced, for the simple reason that the number of wealthy people, even if growing significantly with the arrival of the nouveaux riches in China and elsewhere, is still limited. We are a long way from the fundamental mechanism driving growth, whereby gains in productivity push prices down and have an impact on income that is substantial enough to stimulate demand on an ever increasing scale. We also have to recognize the other side of the coin of this genuine increase in inequality, namely, the fall in median income and the corresponding weakening of the large middle class, whose demand for midrange products and services was a foundation for growth.

It is also worth noting recent trends in the luxury industry, which has successfully striven to produce brands that are lower cost versions of goods that were previously reserved for the rich. As shown by some studies, the diversification of the luxury industry is being accompanied by a sociological change indicating that middle-class households are developing a greater preference for these types of goods (see J. Hoffmann and I. Coste-Manière, 2012 Luxury Strategy in Action, Palgrave Macmillan). This might be a long-term development if it is remembered that preferences are not homothetic, in other words, that lower incomes are not leading back to the map of preferences as it existed previously (before incomes had increased). Many households are trying to maintain the kind of consumption that they have become accustomed to, ultimately at the cost of higher indebtedness, if by chance that is permitted by the financial system. However, the business segment preserved in this way may prove to be fragile, and the performance of the luxury industry could continue to be driven by the conspicuous consumption of genuine luxury products. It is not surprising, then, to observe that, with the continuation of the crisis and its consequent impact on the consumption of the middle class, a company like PPR is planning to hive off certain brands, notably FNAC, in order to focus on the luxury segment.

There is nothing paradoxical about the insolent health of the luxury industry. It goes hand in hand with the heightening difficulties facing industries and companies whose products and services are intended for those on middle-incomes. The constantly increasing divergence in performance between industries and firms depending on their positioning range is merely another sign of a deepening crisis.