Is the eurozone crisis over? The answer is: "yes and no”. Yes, risks of an immediate crisis are reduced. But no, the currency’s survival is not certain. So long as this is true, the possibility of renewed stress remains.
The best indicator of revived confidence is the decline in interest rate spreads between sovereign bonds of vulnerable countries and German Bunds. Irish spreads, for example, were just 205 basis points on Monday, down from 1,125 points in July 2011. Portuguese spreads are 465 basis points, while even Greek spreads are 946 basis points, down from 4,680 points in March 2012. Italian and Spanish spreads have been brought to the relatively low levels of 278 and 362 basis points, respectively.
Behind this improvement lie three realities. The first is Germany’s desire to keep the eurozone intact. The second is the will of vulnerable countries to stick with the policies demanded by creditors. The third was the decision of the European Central Bank to announce bold initiatives – such as an enhanced longer-term refinancing operation for banks and outright monetary transactions for sovereigns – despite Bundesbank opposition. All this has given speculators a glorious run.
Yet that is not the end of the story. The currency union is supposed to be an irrevocable monetary marriage. Even if it is a bad marriage, the union may still survive longer than many thought because the costs of divorce are so high. But a bad romance is still fragile, however large the costs of breaking up. The eurozone is a bad marriage. Can it become a good one?
A good marriage is one spouses would re-enter even if they had the choice to start all over again. Surely, many members would refuse to do so today, for they find themselves inside a nightmare of misery and ill will. In the fourth quarter of last year, eurozone aggregate gross domestic product was still 3 per cent below its pre-crisis peak, while US GDP was 2.4 per cent above it. In the same period, Italian GDP was at levels last seen in 2000 and at 7.6 per cent below its pre-crisis peak. Spain’s GDP was 6.3 per cent below the pre-crisis peak, while its unemployment rate had reached 26 per cent. All the crisis-hit economies, save for Ireland’s, have been in decline for years. The Irish economy is essentially stagnant. Even Germany’s GDP was only 1.4 per cent above the pre-crisis peak, its export power weakened by the decline of its main trading partners.
If all members of the eurozone would rejoin happily today, they would be extreme masochists. It is debatable whether even Germany is really better off inside: yes, it has become a champion exporter and runs large external surpluses, but real wages and incomes have been repressed. Meanwhile, the political fabric frays in crisis-hit countries. Anger at home and friction abroad plague both creditors and debtors.
What, then, needs to happen to turn this bad marriage into a good one? The answer has two elements: manage a return to economic health as quickly as possible, and introduce reforms that make a repeat of the disaster improbable. The two are related: the more plausible longer-term health becomes, the quicker should be today’s recovery.
A return to economic health has three related components: write-offs of unpayable debt inherited from the past; rebalancing; and financing of today’s imbalances. In considering how far all this might work, I assume that the risk-sharing and fiscal transfers associated with typical federations are not going to happen in the eurozone. The eurozone will end up more integrated than before, but far less integrated than Australia, Canada or the US.
On debt write-offs, more will be necessary than what has happened for Greece. Moreover, the more the burden of adjustment is forced on to crisis-hit countries via falling prices and wages, the greater the real burden of debt and the bigger the required write-offs. Debt write-offs are likely to be needed both for sovereigns and banks. The resistance to recognising this is immensely strong. But it may be futile.
The journey towards adjustment and renewed growth is even more important. It is going to be hard and long. Suppose the Spanish and Italian economies started to grow at 1.5 per cent a year, which I doubt. It would still take until 2017 or 2018 before they returned to pre-crisis peaks: 10 lost years. Moreover, it is also unclear what would drive such growth. Potential supply does not of itself guarantee actual demand.
Fiscal policy is contractionary. Countries suffering from private sector debt overhangs, such as Spain, are unlikely to see a resurgence in lending, borrowing and spending in the private sector. External demand will be weak, largely because many members are adopting contractionary policies at the same time. Not least because it is far from clear that the competitiveness of crisis-hit countries has improved decisively, except in the case of Ireland, as Capital Economics explains in a recent note. Indeed, evidence suggests that Italian external competitiveness is worsening, relative to Germany’s. Yes, the external account deficits have shrunk. But much of this is due to the recessions they have suffered.
Meanwhile, the financing from the European Central Bank, though enough to prevent a sudden collapse into insolvency of weak sovereigns and the banks to which they are tied, required rapid fiscal tightening. The results have been dismal. In a recent letter to ministers, Olli Rehn, the European Commission’s vice-president in charge of economics and monetary affairs, condemned the International Monetary Fund’s recent doubts on fiscal multipliers as not "helpful”. This, I take it, is an indication of heightened sensitivities. Instead of listening to the advice of a wise marriage counsellor, the authorities have rejected it outright.
Those who believe the eurozone’s trials are now behind it must assume either an extraordinary economic turnaround or a willingness of those trapped in deep recessions to soldier on, year after grim year. Neither assumption seems at all plausible. Moreover, prospects for desirable longer-term reforms – a banking union and enhanced risk sharing – look quite remote. Far more likely is a union founded on one-sided, contractionary adjustment. Will the parties live happily ever after or will this union continue to be characterised by irreconcilable differences? The answer seems evident, at least to me. If so, this unhappy story cannot yet be over.
Copyright The Financial Times Limited 2013.