December 24th, 2012 | By Nick Sargen
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.
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 own take on the euro-zone's fate is less pessimistic, although I acknowledge there are serious challenges ahead:
Note: This will be the final posting for 2012. We at Fort Washington wish you a Merry Christmas and Happy New Year!