Tensions surrounding the eurozone have eased markedly in the early part of 2012 following the atmosphere of crisis that persisted through the second half of 2011. There is instead a new confidence that financial and economic disaster can be averted.

Tensions surrounding the eurozone have eased markedly in the early part of 2012 following the atmosphere of crisis that persisted through the second half of 2011. There is instead a new confidence that financial and economic disaster can be averted. Several developments have contributed to this optimism, including a change of government in Italy, a large injection of liquidity into the banking system by the European Central Bank (ECB), and a ‘fiscal compact’ among governments. The euro itself has strengthened on currency markets, and the perception of reduced risk can be seen in lower market yields on Italian and Spanish government bonds.

This does not mean that the future of the eurozone is yet assured. The steps taken so far by governments and other bodies are, in fact, widely acknowledged to be inadequate. For months, official responses to the market mayhem – in which it was feared that Italy and Spain would follow Greece, Ireland and Portugal in needing financial rescue, with the risk of debt defaults and huge bank losses – were stumbling, and failed to instil confidence. Even after the more positive recent steps, it is commonly agreed that governments have not yet arranged sufficiently large ‘firewalls’ to ensure that there are adequate amounts of emergency money on hand to deal with a new funding crisis in a member country. Meanwhile, there is still considerable debate about the proper functions of the ECB. In addition, it remains to be seen whether countries that have lagged behind can improve their economic competitiveness so as to reduce imbalances within the eurozone and thus make the common currency viable for the long term.

Nevertheless, even as Greeks protest bitterly against the terms attached to their country’s latest rescue package, there is no doubt that the frenzy of previous months has dissipated and that, while efforts to save the eurozone are still urgent, they can be addressed more calmly.

What changed?

The single-biggest action that took the sting out of the crisis was the ECB’s offer in December to lend unlimited amounts of three-year money to eurozone banks. The first offer under its Long Term Refinancing Operation (LTRO) resulted in €489 billion being loaned to a total of 523 banks. This immediately took the financial system away from the precipice. A loan-repayment problem becomes a debt crisis because of the threat it poses to lending banks. If the problem is big enough, it threatens the health of the entire banking system. That was the situation in the financial crisis of 2008, of which the eurozone crisis is a very large aftershock. In 2008, Western banks stopped lending to each other for fear of bank failures following the collapse of the US mortgage-backed-securities market. By late 2011, a similar situation existed in Europe as markets worried that the rising borrowing costs for Italy and Spain would drive them into defaults. The LTRO, however, eliminated the possibility that sovereign debt problems could cause immediate bank failures.

The manner of the ECB’s intervention was unexpected. For months, there had been calls for it to fire a ‘big bazooka’ to restore confidence and halt the sell-off of government bonds issued by Italy and Spain. Many wanted the ECB to do this by buying large amounts of government bonds, an action that would have the effect of setting a ceiling on sovereign borrowing costs. The ECB had introduced a buying programme for Greece, Ireland and Portugal, and later extended it to Italian and Spanish bonds. But the amounts it purchased were limited, because the bank – established on the model of the German Bundesbank – did not believe it should interfere in fiscal policy. German members of its board strongly objected to bond purchases: its chief economist, Jürgen Stark, resigned and later wrote that governors had ‘stretched the mandate of the ECB to extremes’ and that it was ‘an illusion to believe that monetary policy can solve major structural and fiscal problems in the eurozone’. It was not only German reservations that were holding the ECB back. Its president, Jean-Claude Trichet, and his successor Mario Draghi, who took over in November, also believed that the prime responsibility fell on governments to deal with the eurozone’s problems, and that palliative action by the central bank would lessen the pressure on governments to make unpalatable decisions to deal with economic and financing difficulties.

Draghi’s decision to launch the LTRO came only after Silvio Berlusconi had been ousted as Italian prime minister and as eurozone governments moved towards agreement on a fiscal compact that was intended to tie economic policies much more closely together. Having seen them make progress, the ECB had more confidence that, in taking direct action to provide the desired ‘wall of money’, it would not be throwing the money away or letting ‘euro area leaders off the hook’. And by supporting banks, rather than governments, it was staying within its remit as a central bank and removing the immediate threat of systemic failure.

Buying time

The crisis is not over. There could be further serious disruption if Greece fails to meet the economic and fiscal conditions attached to a second international rescue package – though its debts have by now been largely written off or sold on. While Ireland has made great progress in turning its economy round, it remains vulnerable, as does Portugal. The new governments in Italy and Spain face big challenges in introducing new austerity programmes.

Thus, the risk of debt-repayment problems remains. The firewalls erected to stop panics are insufficient to deal with them. The eurozone was set up on ‘no bailout, no default’ principles and, therefore, went into the sovereign debt crisis with no firewalls at all. It has since established the €440bn European Financial Stability Facility (EFSF) (of which some €250bn has not been committed to rescue packages) and is setting up a permanent European Stability Mechanism (ESM) with €500bn of lending power. Christine Lagarde, managing director of the International Monetary Fund (IMF), has urged Germany, as the largest contributor to both, to fold the outstanding €250bn from the EFSF into the ESM, to increase its size. At the same time, the IMF is asking its members to boost its own emergency lending power by $500bn – though the United States has indicated it will not do so. The existence of larger backstop funding should help to prevent future market worries about problem debtors from turning into panics. But Lagarde has argued that, without a larger firewall, ‘countries like Italy and Spain, that are fundamentally able to repay their debts, could potentially be forced into a solvency crisis by abnormal financing costs.’

More broadly, the measures on which the eurozone as a whole has been able to agree will take time. The fiscal compact, which is at the heart of the German-led response to the crisis, will take years to have real effect. It springs from the belief of German Chancellor Angela Merkel and her finance minister Wolfgang Schäuble that lack of fiscal discipline is at the heart of the eurozone’s problems and that its imposition is the only true route to solving them. The compact, agreed at a summit in December 2011 and to be enshrined in a new treaty between 25 out of 27 European Union members, reinforces the boundaries set in the 1997 Stability and Growth Pact – budget deficits not to exceed 3% of GDP, total debt not to exceed 60% – with a new limit on the ‘structural deficit’ of 0.5% (though this would be hard to pin down). Countries are required to introduce balanced-budget legislation, and there are stronger mechanisms for consultation and enforcement, with the aim of creating a ‘common economic policy’. However, under this approach, many governments could be committed for years to austerity programmes that would restrict Europe’s ability to grow out of its economic and financial problems.

European leaders do recognise the need to stimulate economic growth. Though budget-cutting is inherently likely to inhibit growth, it is possible for governments engaged in deficit-reduction programmes to introduce targeted incentives aimed at boosting business investment in future growth. However, critics argue that tough and coordinated fiscal discipline is at best only dealing with part of the problem, and may even be aimed at the wrong target. They argue that it was not fiscal irresponsibility that led to the financial difficulties of most problem eurozone countries. Instead, the crisis was caused largely by excessive and ill-judged lending and borrowing in the private sector. In Ireland, for example, banks expanded rapidly, became over-extended and had to be rescued. In Spain, a real-estate bubble burst. Both countries had budget surpluses as recently as 2007.

Some economists believe European governments should be focusing less on the need for austerity and far more on measures to stimulate growth. Without such a focus, they say, Europe risks a ‘lost decade’ of snail’s-pace growth and persistently high unemployment. For other observers, however, governments simply have no alternative and must reduce budget deficits by cutting spending and raising taxes, so as to escape the fate of Greece. For them, this is part of boosting economic competitiveness, as all countries must try to do if they run into payment problems.

Longer-term issues

The fiscal compact, national deficit-cutting programmes, the firewalls, the injection of liquidity into banks: all are elements of the solution being arrived at by eurozone governments to reduce the risk of widespread sovereign defaults and restore confidence in the future of the common currency. Even before these measures were agreed, the euro area had changed in another important way: markets now set different risk premiums on its members. It seems highly unlikely that the spreads between the interest rates will narrow again to nothing. The decade of uniform interest rates for eurozone members seems in retrospect to be an aberration – one which provided cheap money to countries which otherwise would have had to pay higher rates, and helped to make them less competitive.

The most important outcome of the crisis, however, has been the repeated expression by eurozone governments of their commitment to the future of the euro. While there has been grumbling in northern countries about a ‘transfer union’ and bailing out profligate southerners, and in southern countries about terms being dictated by the north, political solidarity has held at each summit and in each national parliamentary vote. It is true that the EU’s reaction to the crisis has seemed uncoordinated and lagging behind events, but this was inevitable when a bargaining process was under way between governments and international bodies as to who would bear the costs of rescue. But when the future of the euro has been at stake, unpopular measures have been agreed. This political will is just as important as all the economic and financial measures being taken to save the euro. It means the currency seems likely to survive, and probably with Greece remaining in it. At the same time, political backing cannot be taken for granted. There is a limit to how long Germany can openly determine the future living conditions of citizens of problem debtors. Therefore, new institutional arrangements agreed at the December summit are particularly important. If they work, they will take some of the political sting out of future austerity programmes.

Several issues remain unresolved. Firstly, there remain calls for ‘eurobonds’, issued by governments and guaranteed by fellow euro members, to limit borrowing costs and restore confidence. Germany has rejected this as it would reduce pressure on governments to take responsibility for their economies. But if faith in the euro’s future gradually returns, this seems a possible step towards cementing it. Secondly, a common central bank seems not to provide an adequate backstop to a country in crisis: a University of Leuven paper finds that interest rate spreads for countries with rising debts in the eurozone are much wider than for ‘stand-alone’ countries (with their own central bank) in similar economic situations. An enhanced role for the ECB as lender of last resort seems likely to be discussed further. Thirdly, Lagarde has called for deeper financial integration to break the cycle of troubled debtors damaging banks, whose problems then contribute to debtors’ woes. Banks’ capital requirements are being raised, but further measures to bolster the system could be mooted.

Finally, the biggest question remains: is it feasible in the long term to have a single currency, a single central bank and monetary policy, but 17 or more economic and fiscal policies? Since members sell goods, services and labour to each other as well as globally, trade imbalances between members will naturally occur, and some countries will tend to be more competitive than others. According to Lagarde, ‘at the euro-area level, the fundamentals look good – the current account is balanced and inflation and the fiscal deficit are both low. But the euro area does not handle internal imbalances well.’ That seems to be the crux of the debate about the euro’s future. Even if all eurozone members were to meet the budget-deficit targets of the fiscal compact, there could still be wide differences between their competitiveness. Investment would naturally be directed to the more competitive countries, and not to those with higher unit labour costs and lower productivity. Capital will tend to leave them and flow to healthier eurozone members. The weaker countries would, increasingly, be left behind.

Even if Greece and other countries were to manage to reform labour markets and reduce costs, it seems unrealistic to expect them to become as competitive as Germany. But because their exchange rate is also Germany’s exchange rate, they are unable to adjust through the traditional route of currency devaluation.

The euro’s long-term future must, therefore, depend not only on political will, economic growth and adequate emergency rescue arrangements, but crucially on the ability of its members to set themselves on a path of convergence in economic competitiveness. Not only would Greece, Italy and Spain have to become more competitive, but Germany would have to become relatively less so. This issue has not yet been addressed.

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