At the start of EMU in 1999, economists had formed a set of expectations on how financial markets would behave inside the eurozone and on the euro’s implications for financial market volatility. Now that the banking crisis has turned into a deep economic recession (including elements of a sovereign debt crisis), it is time to assess whether these expectations have been met.
First and foremost, the introduction of the euro was meant to permanently do away with the crises, volatility and speculation in the currency markets which had plagued Europe in the pre-euro era. Getting rid of intra-European currency volatility was (and still is) deemed important because competitive devaluations threaten the sustainability of the single market in goods and services.
Second, Europe’s bond markets were expected to play a role in disciplining fiscal policy. The idea was that bondholders would enforce fiscal discipline by charging high risk premia on public debt of countries with lax fiscal policies. Whether this was ever going to work or whether markets would count on a European bailout has been controversial since the start.
Third, convergence in macroeconomic fundamentals would yield similar convergence in the capital markets. The ECB’s goal of keeping inflation stable at around 2% would result in high cross-country correlations in bond returns. Likewise, increased economic integration and a convergence in economic growth would reduce the country effects which have historically been such an important source of variation in stock returns. As a result sector effects were expected to replace country effects as the dominant driver of European stock returns.
Have these expectations materialized? As the eurozone has held together, the first expectation undoubtedly has. The small-scale speculation against the euro that we have witnessed lately is at worst a minor nuisance for the large closed eurozone economy and gives at best a small boost to its competitiveness. While a few eurosceptics may have hoped (or indeed still hope) that the Greek debt crisis spells the disintegration of the euro area, no real threat to the integrity of the eurozone and the single market has yet emerged.
This doesn’t mean that all is well. Pre-crisis expectations of continued macroeconomic convergence have made way for fears of economic divergence, especially between the north and the south. While all eurozone members have been hit by recession at about the same time, the severity of the recession differs markedly across countries and the pace of recovery is likely to be uneven as well. In addition there are the well-known cross-country differences in the state of the public finances. This implies that uncertainty regarding the macroeconomic outlook will continue to preoccupy financial markets. Inside a monetary union macroeconomic uncertainty cannot translate into currency volatility. It will thus pop up in different places.
One place where volatility has already increased is the bond market. Interest spreads between eurozone government bonds have widened substantially since the start of the credit crisis and peaked following the uncovering of the true Greek deficit numbers. The same intra-European macroeconomic tensions which in the pre-euro era would have led to a currency crisis (such as the 1992-1993 EMS crisis) now spill over into the bond markets. In this sense we’ve just substituting one type of volatility for another. The belated bond market response to the Greek fiscal problems also indicates that the second expectation, that bond market would discipline fiscal policy, has not worked. The bond market didn’t prevent Greek fiscal profligacy, but will make it much harder for the new Greek government to clean up the mess.
The second place where macro uncertainty pops up is the stock market. A typical stock market response in a pre-euro currency crisis was for share prices to recover quickly following a devaluation, as firms were expected to benefit from a weaker currency and a looser monetary policy. This is in stark contrast to the current situation in countries like Greece and Ireland, where competitiveness has to be restored the hard way. But budget cuts, wage cuts and higher taxes create a much less favourable environment for stock prices. The quick and certain effect of devaluation on competitiveness, even if it may not last forever, pleases stock markets more than the prospect of a long, hard and uncertain struggle with parliaments and labour unions to reform the public sector and the labour market. Depending on a country’s success in economic reform, we may expect the country effect to creep back into stock returns. For the foreseeable future, Europe’s bond and stock markets will remain nervous, as they continue to monitor the progress that weak member states make in adapting to the rigors of the eurozone.