Outlook 2012 ( 515 KB )

 

  The future of the euro area continues to be at the mercy of the outcome of a sovereign debt crisis which will soon be two years old, which has already put an end to several governments and has jeopardized the incipient economic recovery. But, no matter how serious it may seem now, and it is, this will all become merely anecdotal if the ultimate victim of the crisis ends up being... the single currency itself.

  George Papandreu's failed initiative to hold a referendum on the Greek bailout plan opened up Pandora's box, placing in the mouths of the French and German authorities the threat of expelling Greece from the European Monetary Union. What was previously unthinkable suddenly appeared to be a real possibility. Nonetheless, whichever way you look at it, it's still crazy to think that the euro might be dismembered: the mere threat of the financial tsunami this would cause should ensure that European (and global) authorities will do their utmost to avoid such an outcome. The question is whether they have drawn up and are following the right strategy to overcome the crisis and bolster the viability of the euro area once and for all; or whether they have limited themselves to reacting to the ups and downs of the markets and to merely patching up the situation.

  Prescribing a treatment requires, above all, a correct diagnosis of the illness, in this case the worst crisis faced by Europe since the Second World War. An examination should discern between the fundamental causes of the crisis (the root of the uncertainty regarding the single currency's viability) from other urgent but auxiliary factors, although these are also buffeting the financial markets.(1)

  The ultimate reason why European public debt has gone astray lies in structural deficiencies in the euro area's design that restrict its capacity, firstly, to prevent and, secondly, to put an end to moments of crisis such as the present. These shortcomings come as no surprise. Since it was conceived, it has been common knowledge that the countries comprising the EMU did not constitute an optimal monetary area and that, in the long term, the institutional structure given to the single currency would not be enough, particularly when the time came to handle its first big crisis. An optimal design would have required one of three things: a highly mobile labour factor, greater price and wage flexibility or, in the absence of both of these, a degree of fiscal integration that would partly make up for the lack of the exchange rate as a means of adjustment when faced with an external shock that affects different members of the union to differing degrees. However, none of these three conditions has occurred in the EMU.

  (1) See «La crisis del euro: causas últimas y soluciones duraderas». Jordi Gual. Revista de Occidente no. 367, December 2011. Fundación José Ortega y Gasset.

  The mechanisms aimed at alleviating such lacks in terms of preventing imbalances within the union, essentially established in the Stability and Growth Pact, did not work. Neither did the markets fulfil their disciplinary role until the crisis occurred (Greek 10-year bonds enjoyed a spread of barely 0.1% compared with German bonds in 2005, in spite of huge differences in fundamentals). We're only too aware of the upshot of this concoction of faults: the single currency widened the union's external imbalances to excessive levels and deficit countries accumulated unprecedented levels of debt; the recession arrived and governments resorted to their public coffers to lessen its impact, increasing their economies' external liabilities; a change in government in Greece revealed a bigger hole than had been acknowledged... and all the alarm bells started ringing. The rest can be included largely in what might be called the local causes or urgent problems of the crisis.

  These local causes come from the difficulty in interrupting the following vicious circle: the austerity measures required from countries whose sovereign solvency is arousing mistrust due to the critical state of their public accounts hinder both their growth prospects and the solvency of their private sector. This makes fiscal adjustment even more difficult, feeding back into a perverse spiral that, if not halted, can lead to such a high level of mistrust and turbulence that it ends up infecting other, fundamentally solvent economies.

  Armed with this diagnosis, the time has come to prescribe a treatment which will naturally differ depending on the objective. If our aim is to make the system more robust in order to avoid any future outbreaks, then we have to attack the problem at source, in other words, correct the union's deficient institutional system, achieving greater common governance which would, in all probability, be a long, complex process. If, at the same time, we need to put a stop to the increasing ills of affected countries (in other words, keep their risk premia within sustainable limits) or, should this be contagious (and it is), avoid an epidemic (i.e. stop the sovereign risk premia of the rest of the member states from rocketing), the right remedy will require a sufficiently powerful shock treatment to break the vicious circle described previously.

  The increasing tension in the financial markets shows that, for the time being, this spiral is still in operation and that the measures adopted to date have not been enough to slow up the contagion (and some of them have even been counterproductive). The soothing effect of the last euro area summit, which agreed a voluntary restructuring of Greek debt with a 50% write-down, the recapitalization of the main European banks, the enlargement and flexibilization of the European Financial Stability Fund and to advance towards more robust pan-European governance, hardly lasted twenty-four hours. Not only did tensions not abate, they even intensified: they swallowed up Italy, showed no mercy to Spain and Belgium and reached the very heart of the euro area when the risk premia of France, Austria and even the Netherlands started to dance to the song of doubt (see the graph below).

  In some sectors, deficient institutional management is being blamed for the steady deterioration of the crisis, as much lacking in resources as resolve. Repeated deferment of an inevitable restructuring of Greek debt and the opposition of countries in the north of Europe, and particularly Germany, to shock treatments to soothe the tension (such as creating a common bond, the so-called Eurobond, which would set up a single risk premium, or more aggressive intervention by the ECB in buying up sovereign debt) are exasperating markets that want fast solutions that can sweep away the uncertainty hovering over the euro area's sovereign risk at one fell swoop.

  However, albeit risky, the strategic line followed by the EMU leaders in handling the crisis is consistent with a long-term view, prioritizing the union's greater solidity above its short-term stability. In the absence of an integrated, flexible labour market, the imbalances threatening the euro can only be corrected via institutional changes, be they on a national scale, with reforms that allow a flexible downward adjustment to prices and costs, i.e. by arranging an internal devaluation given that monetary devaluation is impossible; or be it on a pan-European scale, advancing towards greater fiscal and, possibly, political integration.

  Any institutional reform requires resolve and time, and this might help to explain why the European authorities have taken the steps they have taken. Delaying the restructuring of Greek debt would have been to slow up contagion to other economies that are solvent but have liquidity problems, giving them time to do their homework and thereby verify their solvency. Similarly, rejecting any proposal that ends the recently restored disciplinary function of the markets (such as Eurobonds) aims to pressurize countries forced to correct internal imbalances to continue with their adjustments (avoiding the moral risk entailed in returning to a single risk premium).

  In short, the scale achieved by the crisis might be the only way to convince governments and citizens that both adjustments and greater fiscal integration are inevitable requirements to guarantee the survival of the single currency; the only way to generate the necessary resolve to advance along these lines. Nonetheless, the markets have not relented and resorting to some kind of shock treatment therefore seems inevitable in order to achieve this long-term goal (probably via the massive intervention of the ECB), to stop emergencies from breaking out or simply to gain time... in case there's anyone left who still needs to be persuaded that the future of Europe, without the euro, looks very bleak indeed.

  This box was prepared by Marta Noguer

  International Unit, Research Department, "la Caixa"

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