The eurozone’s delayed reckoning
NEW YORK — The risks facing the eurozone have been reduced since the summer, when a Greek exit looked imminent and borrowing costs for Spain and Italy reached new and unsustainable heights. But, while financial strains have since eased, economic conditions on the eurozone’s periphery remain shaky.
Several factors account for the reduction in risks. For starters, the European Central Bank’s (ECB’s) "outright monetary transactions" programme has been incredibly effective: interest rate spreads for Spain and Italy have fallen by about 250 basis points, even before a single euro has been spent to purchase government bonds. The introduction of the European Stability Mechanism (ESM), which provides another €500bn to be used to backstop banks and sovereigns, has also helped, as has European leaders’ recognition that a monetary union alone is unstable and incomplete, requiring deeper banking, fiscal, economic and political integration.
But, perhaps most important, Germany’s attitude towards the eurozone in general, and Greece in particular, has changed. German officials now understand that, given extensive trade and financial links, a disorderly eurozone hurts not just the periphery but the core. They have stopped making public statements about a possible Greek exit, and just supported a third bail-out package for the country. As long as Spain and Italy remain vulnerable, a Greek blowup could spark severe contagion before Germany’s election next year, jeopardising Chancellor Angela Merkel’s chances of winning another term. So Germany will continue to finance Greece for the time being.
Nonetheless, the eurozone periphery shows little sign of recovery: gross domestic product (GDP) continues to shrink, owing to ongoing fiscal austerity, the euro’s excessive strength, a severe credit crunch underpinned by banks’ shortage of capital, and depressed business and consumer confidence. Moreover, recession on the periphery is now spreading to the eurozone core, with French output contracting and even Germany stalling as growth in its two main export markets is either falling (the rest of the eurozone) or slowing (China and elsewhere in Asia).
Moreover, balkanisation of economic activity, banking systems and public-debt markets continues, as foreign investors flee the eurozone periphery and seek safety in the core. Private and public debt levels are high and possibly unsustainable. After all, the loss of competitiveness that led to large external deficits remains largely unaddressed, while adverse demographic trends, weak productivity gains, and slow implementation of structural reforms depress potential growth.
To be sure, there has been some progress in the eurozone periphery in the past few years: fiscal deficits have been reduced, and some countries are now running primary budget surpluses (the fiscal balance excluding interest payments). Likewise, competitiveness losses have been partly reversed as wages have lagged productivity growth, thus reducing unit labour costs, and some structural reforms are ongoing.
But, in the short run, austerity, lower wages and reforms are recessionary, while the adjustment process in the eurozone has been asymmetric, and recessionary and deflationary. The countries that were spending more than their incomes have been forced to spend less and save more, thereby reducing their trade deficits; but countries like Germany, which were over-saving and running external surpluses, have not been forced to adjust by increasing domestic demand, so their trade surpluses have remained large.
Meanwhile, the monetary union remains an unstable disequilibrium: either the eurozone moves towards fuller integration (capped by political union to provide democratic legitimacy to the loss of national sovereignty on banking, fiscal and economic affairs), or it will undergo disunion, dis-integration, fragmentation, and eventual breakup. And, while European Union (EU) leaders have issued proposals for a banking and fiscal union, now Germany is pushing back.
German leaders fear the risk-sharing elements of deeper integration (the ESM’s recapitalisation of banks, a common resolution fund for insolvent banks, eurozone-wide deposit insurance, greater EU fiscal authority, and debt mutualisation) imply a politically unacceptable transfer union whereby Germany and the core unilaterally and permanently subsidise the periphery. Germany thus believes the periphery’s problems are not the result of the absence of a banking or fiscal union; rather, on the German view, large fiscal deficits and debt reflect low potential growth and loss of competitiveness due to the lack of structural reforms.
Of course, Germany fails to recognise that successful monetary unions such as the US have a full banking union with significant risk-sharing elements, and a fiscal union whereby idiosyncratic shocks to specific states’ output are absorbed by the federal budget. The US is also a large transfer union, in which richer states permanently subsidise the poorer ones.
At the same time, while proposals for a banking, fiscal and political union are being mooted, there is little discussion of how to restore growth in the short run. Europeans are willing to tighten their belts, but they need to see a light at the end of the tunnel in the form of income and jobs growth. If recessions deepen, the social and political backlash against austerity will become overwhelming: strikes, riots, violence, demonstrations, the rise of extremist political parties, and the collapse of weak governments. And, to stabilise debt-GDP ratios, the denominator must start rising; otherwise, debt levels will become unsustainable, despite all efforts to reduce deficits.
The tail risks of a Greek exit from the eurozone or a massive loss of market access in Ita