The Eurozone’s Calm Before the Storm

NEW YORK – A little more than a year ago, in the summer of 2012, the eurozone, faced with growing fears of a Greek exit and unsustainably high borrowing costs for Italy and Spain, appeared to be on the brink of collapse. Today, the risk that the monetary union could disintegrate has diminished significantly – but the factors that fueled it remain largely unaddressed.

Several developments helped to restore calm. European Central Bank President Mario Draghi vowed to do “whatever it takes” to save the euro, and quickly institutionalized that pledge by establishing the ECB’s “outright monetary transactions” program to buy distressed eurozone members’ sovereign bonds. The European Stability Mechanism (ESM) was created, with €500 billion at its disposal to rescue eurozone banks and their home governments. Some progress has been made on a European banking union. And Germany has come to understand that the eurozone is as much a political project as an economic one.

Moreover, the eurozone recession is over (though five periphery economies continue to shrink and recovery remains very fragile). Some structural reform has been implemented, and a lot of fiscal adjustment has occurred. Internal devaluation (a fall in unit labor costs to restore competitiveness) has occurred to some extent (in Spain, Portugal, Greece, and Ireland, but not in Italy or France), thus improving external balances. And even if such adjustment is not occurring as fast as Germany and other core eurozone countries would like, they remain willing to provide financing, and governments committed to adjustment are still in power.

But beneath the surface calm of lower spreads and lower tail risks, the eurozone’s fundamental problems remain unresolved. For starters, potential growth is still too low in most of the periphery, given aging populations and low productivity growth, while actual growth – even once the periphery exits the recession in 2014 – will remain below 1% for the next few years, implying that unemployment rates will remain very high.

Meanwhile, levels of private and public debt – both domestic and foreign – are still too high, and they continue to rise as a share of GDP, owing to slow or negative output growth. This means that the issue of medium-term sustainability remains unresolved.

At the same time, the loss of competitiveness has been only partly reversed, with most of the improvement in external balances being cyclical rather than structural. The severe recession in the periphery has caused imports there to collapse, but lower unit labor costs have not boosted exports enough. The euro is still too strong, severely limiting the improvement in competitiveness needed to boost net exports in the face of weak domestic demand.

Finally, while the fiscal drag on growth is now lower, it is still a drag. And its effects are amplified in the periphery by an ongoing credit crunch, as undercapitalized banks deleverage by selling assets and shrinking their loan portfolios.

The larger problem, of course, is that progress toward banking, fiscal, economic, and political union – all essential to the eurozone’s long-term viability – has been too slow. Indeed, there has been no progress whatsoever on the latter three, while progress on the banking union has been limited. Germany is resisting the risk-sharing elements of such a union: common deposit insurance, a common fund to wind up insolvent banks, and direct equity recapitalization of banks by the ESM.

Germany fears that risk-sharing would become risk-shifting, and that any form of fiscal union would likewise turn into a “transfer union,” with the rich core permanently subsidizing the poorer periphery. At the same time, the entire regulatory process for the financial sector is pro-cyclical. The new Basel III capital-adequacy ratios, the ECB’s upcoming asset-quality review and stress tests, and even the European Union’s competition rules (which force banks to contract credit if they receive state aid) all imply that banks will have to focus on raising capital – and thus not providing the financing needed for economic growth.

Moreover, the ECB is unwilling to be creative in pursuing policies – like those embraced by the Bank of England – that would ameliorate the credit crunch. Unlike the US Federal Reserve and the Bank of Japan, it is not engaging in quantitative easing; and its “forward guidance” that it will keep interest rates low is not very credible. On the contrary, interest rates remain too high and the euro too strong to jump-start faster economic growth in the eurozone.

In the meantime, austerity fatigue is rising in the eurozone periphery. The Italian government is on the verge of collapsing; the Greek government is under intense strain as it seeks further budget cuts; and the Portuguese and Spanish governments are having a hard time achieving even the looser fiscal targets set by their creditors, while political pressures mount.

And bailout fatigue is emerging in the eurozone core. In Germany, the next coalition government looks set to include the Social Democrats, who are pushing for a bail-in of the banks’ private creditors, which would only exacerbate balkanization of the eurozone’s banking system; and populist parties throughout the core are pushing against bailouts for banks and governments alike.

So far, the grand bargain between the core and the periphery has held up: the periphery continues austerity and reform while the core remains patient and provides financing. But the eurozone’s political strains may soon reach a breaking point, with populist anti-austerity parties in the periphery and populist anti-euro and anti-bailout parties in the core possibly gaining the upper hand in next year’s European Parliament elections.

If that happens, a renewed bout of financial turbulence would weaken the eurozone’s fragile economic recovery. The calm that has prevailed in eurozone financial markets for most of the past year would turn out to be only a temporary respite between storms.

This piece is cross-posted from Project Syndicate with permission.

4 Responses to "The Eurozone’s Calm Before the Storm"

  1. Andrew_M_Garland   October 6, 2013 at 5:36 pm

    Jobs Needed To Keep Up With Population Growth
    10/2012 – Economic Populist
    === ===
    For August 2012, those not counted in the US labor force, but report they actually want and need a job, increased by 403,000 in a month. That, folks, should have you horrified. Literally we have desperate and destitute people falling through the statistical crevasse, into the abyss where they can only shout out from the numerical darkness, yes I want a job!
    === ===

    Politicians have defined "recession" as "two quarters of decreasing national production". This ignores that a growing US population needs about a 3% increase in yearly production to stay even in prosperity. When production grew in 2012 at a 1.5% annual rate, that fell below break-even, but Obama and our government economists say that is growth, not a recession.

    This definition of a recession is quite lenient on the politicians, who should be blamed for bad policy whenever growth in production falls below population growth.

    This reminds me of the classic scene in Dumb and Dumber in which Jim Carey evaluates the news about his hopes for a relationship. He has a quite forgiving definition.
    Dumb and Dumber 'There's a Chance'

    Man: So, what are my chances with you? One out of a hundred?
    Woman: No. Maybe one in a million.
    Man: [pauses, smiles] So, you're telling me that there is a chance!


  2. Aegean1972   October 10, 2013 at 7:27 am

    Excellent points from Roubini. Europe is risking to blow the lid off (if they continue to push Greece further to austerity) and create a financial-crisis of massive proportions, at the totally wrong time (US shut-down + debt ceiling). After 4 years of massive ass-kicking, Greece is showing serious signs of organization and future potential. Their gmvnt has overdelivered in terms of organizing the state. But they ve reached their breaking-point as far as austerity, unemployment and taxes. Pushing them more would create elections, over-turn the conservative gvmnt and elect 1980's style socialists who will turn Greece into another "Egypt" in NO TIME (less that 6 months).

  3. Aegean1972   October 10, 2013 at 7:28 am

    PART 2:

    Europe has managed (so far) to fool the markets, by making a larger Euro-problem seem like a localised "Greek problem". In reality Greece is only a small part of a bigger Euro-south problem. Italy, Spain, France are too big to save. By pushing Greece into more austerity and new elections, socialists will take over and then say bye-bye to stability in the region. In that case Greece will be kicked out of the EU and the spreads of Italy and the rest of the problematic countries will hit 1000-points in NO TIME. By then the Euro-problem will be massive and Germany will be seriously thinking of "getting outta there" and back to the mark. This senario isnt far fetched. This senario is very real, if they keep pushing Greece for more austerity.
    So Europe must decide what they want. Make Greece a success story and have slight growth (>1%) all over Europe or for all hell to break loose? Dont have to be a nuclear scientist to figure this out.

    • debbbbeeee   October 14, 2013 at 4:55 pm

      The problem isn't greece, it's the "too big to fail" countries. There's no point in saving greece whilst Italy, Spain, and France are all heading in the same direction at different rates of volocity. With the Front National winning Brignolles today and Berlusconi on the prowl (albeit with mixed results), the "popularist" politics will make it impossible for the politicians in these Big 3 to deliver the restructuring required to fit with their northern counterparts. There are only 3 options in my view:

      1. A Neuro with Southern Europe (including France) retaining the current Euro and revaluing
      2. Full breakup
      3. Full political union.

      Unfortunately the popularist politics now makes option 3 impossible. I believe that option 1 is the likely outcome and you're not being far fetched at all.