Macro

Wither Europe?

December 24th, 2012 | By Nick Sargen

Highlights

  • After two years of escalating tensions in the euro-zone, financial markets have calmed recently following the decision to grant the European Central Bank (ECB) authority to purchase sovereign debt of euro-zone members. This has caused some observers to question whether the worst of the crisis is past.
  • At a conference of international economists and policymakers this past week, the over-riding sentiment was decidedly negative. The main concerns were: (i) austerity programs are de-stabilizing and (ii) there is little incentive for creditor countries to boost financial transfers. Therefore, many participants believe tensions will re-escalate at some point.
  • My own take is less dire, as I believe the authorities will take necessary measures to avert a break-up. Also, while Europe is likely to remain in recession well into 2013, the deficit countries are embarking on much-needed structural reforms and their current account positions are improving. The biggest challenge will be to transform the euro-zone into a full-fledged fiscal union, which is unlikely anytime soon.

Euro-zone Tensions Ease

Following two years in which tensions in the euro-zone escalated fairly steadily, financial markets have calmed in the past six months. This is evident in a variety of indicators since June: (i) the Euro Stoxx 50 index, the leading index for blue chip companies in the region, has increased 17% and is currently hovering at its highest level in 18 months; (ii) credit spreads for troubled sovereigns — Greece, Ireland, Italy, Portugal and Spain — have narrowed substantially versus Germany; and (iii) the euro has strengthened against other key currencies.

This turnaround is a response to several developments. The most important is the increased commitment by the ECB to backstop the euro and to act as a true lender of last resort. As tensions in the euro-zone reached a fever pitch in June, Mario Draghi stated that the role of the euro was not in question, and he pressed for the ECB to have the authority to purchase debt of sovereigns in the union. This action was followed by steps to grant the ECB authority to supervise and regulate banks in the euro-zone. On the political front, the newly-elected Greek government pledged to meet the terms for financial assistance that are set by the troika (European Commission, ECB and IMF). Collectively, these developments have lessened the risk of a financial crisis spreading throughout the region.


But Risks Persist

In light of these developments, some observers have questioned whether the euro-zone is at a turning point similar to what transpired in the United States in the Spring of 2009, when the financial system stabilized. With this prospect in mind, I attended a conference in Vienna that was attended by economists and policymakers, where the principal issue discussed was the fate of the euro-zone.

The over-riding sentiment at the conference was decidedly negative, and there was only brief recognition of the recent accomplishments. The keynote speaker – Professor Paul De Grauwe of the London School of Economics – focused on "design failures" in the union that left it vulnerable to speculative attacks. They include: (i) the inability of the ECB to act as a lender-of-last resort for the banking system or government bond markets (until very recently); and (ii) the lack of automatic stabilizers at the national level. De Grauwe argued that monetary union can exacerbate booms and busts at the national level, because there is no possibility of exchange rate adjustment and only one interest rate exists for the entire union. When a crisis unfolds, moreover, the burden of adjustment invariably falls on the debtor nation(s) while creditor nations attempt to enforce discipline. Therefore, instead of counter-cyclical fiscal policy being deployed, the policy response typically is pro-cyclical.

De Grauwe went on to consider the steps that could be taken to redesign the euro-zone. He acknowledged the recent actions to expand the authority of the ECB including the program of "Outright Monetary Transactions", which authorize it to purchase sovereign debt, have stabilized conditions in the short run. However, he maintained these programs are not sufficient by themselves. In the medium term, he believes austerity programs in the deficit countries should be relaxed, while the creditor countries should pursue more expansionary policies. Over the long term, he favors a full fiscal union that would consolidate national debts under a federal authority, and which would protect member states from being forced into default by financial markets.

There was general agreement among the participants that attempts to impose austerity measures on the deficit countries were too severe and were making it more difficult for them to stabilize their debt/GDP ratios. The consensus view was that the euro-zone periphery would stay in recession for most of 2013 and that the core economies would barely grow. At the same time, most of the conference attendees felt there was little impetus for countries to surrender their political sovereignty or to agree on greater burden sharing in the foreseeable future.


My Take: Evolution not Revolution

My own take on the euro-zone's fate is less pessimistic, although I acknowledge there are serious challenges ahead:

  1. The most encouraging development is the diminished risk of a financial melt-down. Market tensions peaked in May-June, when investors feared a possible Greek exit would produce a run on European banks that would mimic what happened in the U.S. following Lehman's collapse. Meanwhile, however, the new powers granted to the ECB have lessened the chances of this happening.
  2. The debtor countries are adjusting, albeit painfully. There is no denying that the debtor countries have experienced painful reductions in output, employment and wealth. According to Morgan Stanley's head of emerging markets, for example, Greek GDP is now 28% below its previous trend, while Spain's GDP is off by 16%. Moreover, the Greek stock market fell by 90% at its low, while the average decline for the European periphery was 70%. From this perspective, it's easy to understand why many economists believe there are limits to how far austerity can go. At the same time, these countries need to persevere with long-term structural reforms to make their labor markets more flexible and their economies more competitive.
  3. Progress towards full fiscal union will be very gradual. One of the main challenges confronting European policymakers is the lack of agreement about what constitutes end game. While some observers believe the goal is to create the European equivalent of the United States, others think this is highly unlikely given the diversity of countries and heritages. For this reason, German Chancellor Angela Merkel has indicated that progress toward a federal union is likely to occur "step by step" rather than through a grand bargain. Accordingly, I believe it is unrealistic for investors to expect that the European Union will be transformed quickly. But this does not mean the euro-zone is flawed or will cease to exist.

Note: This will be the final posting for 2012. We at Fort Washington wish you a Merry Christmas and Happy New Year!