For the third year in a row, the eurozone is the weakest link in the world economy. In 2010, attention was focused on responses to the crisis on the eurozone periphery – Greece, Portugal, and Ireland.
In 2011, the crisis moved to the core, with Italy and Spain feeling the heat, and concerns mounting about the viability of the eurozone itself. The question for 2012 is whether those tensions will abate or reach a new climax. Once again, the Greek crisis is the focus of attention and epitomises Europe’s failings. Once again, hard decisions have to be made about debt restructuring and the provision of further assistance to Athens. And once again, the Europeans have to accept that the situation is more serious than they thought.
But the depth of Greece’s woes should not obscure the fact that it is a small economy and, in many respects, an extreme, special case. No other country flouted the European Union’s budget rules the way Greece did, or has accumulated as large a public-debt burden, and no other EU country combines to the same extent a dysfunctional state and an uncompetitive private economy.
The real battle is being fought in Italy and Spain. Both countries’ borrowing conditions deteriorated in the second half of 2011. Both are so large – accounting for 17% and 11% of eurozone GDP, respectively – that financing them through multilateral assistance would strain, if not exhaust, the resources of the eurozone and the International Monetary Fund. Both recently installed new, reform-minded governments. And both are struggling to rebuild competitiveness, foster growth, restore fiscal soundness, and clean up banks’ balance sheets. If they succeed, the euro will survive; if they fail, it won’t, at least in its present form.
That is why discussions over the last few months have largely, if implicitly, been about how to support adjustment and reform in Italy and Spain. Proposals to permit the European Central Bank to intervene more decisively in bond markets, or to increase the size of the “firewall” by leveraging the European Financial Stability Facility (EFSF), were intended to set an upper limit on interest rates paid by Italy and Spain on their debt emissions.
Similarly, proposals to create common bonds were intended to quell expectations of insolvency by ensuring that these countries would eventually be able to borrow against their eurozone partners’ guarantee. All of the discussions were couched in general terms, but everybody had the same specific countries in mind.
None of these proposals, it seems, will be implemented anytime soon. The ECB has bought some Italian and Spanish bonds, and it might buy more, but it has made clear that it is not ready to commit to a ceiling for long-term interest rates. The EFSF’s size will be increased by accelerating the creation of the permanent European Stability Mechanism, and by letting it overlap with the EFSF. But the EFSF’s capacity will remain at roughly €500 billion – well below the €1 trillion-plus envisaged by those who advocate bringing massive financial firepower to bear (the so-called “bazooka solution”).
Likewise, Eurobonds are officially off the agenda, at least for now. Rather, Europe is putting in place a new fiscal compact to ensure that all eurozone countries adopt and implement stringent budgetary rules.
These choices partly reflect pragmatic concerns: All of the financial-engineering schemes that have been proposed to protect Italy and Spain from aggravated borrowing conditions raise legal, political, or governance difficulties. But there is a principle at issue as well: It is thought (particularly in Germany) that protection from market pressure would only impede adjustment and reform.
Indeed, the perception in Northern Europe is that only serious strains provide the required incentives to overcome domestic political and social obstacles to slashing public spending and reforming labour markets. For Southern Europe, no pain means no gain: A deep recession and a sharp increase in unemployment may be the price of lasting improvements in productivity and competitiveness.
This reasoning is not without justification. Soon after the ECB began buying Italian bonds last August, then-Prime minister Silvio Berlusconi’s government backtracked on its commitments to tax reform. Even though it later reversed its stance, the episode was widely regarded as clear evidence of the moral-hazard effect of ECB support. Only after the bond market turned on Berlusconi again was he replaced by the reform-minded Mario Monti.
But the strategy is a high-risk gamble. Governments may need incentives to act, but they also need to be able to show their citizens that reform pays. If, after a few quarters of fiscal adjustment and painful reform, output is lower, unemployment higher, and the outlook darker, governments may soon lose public support and reform may stall, as we have seen in Greece. Reform-minded teams may lose power to populists.
Furthermore, a degraded macroeconomic and financial environment increases the likelihood of bank failures, with immediate consequences for public finances and economic confidence.
These risks are compounded by the need for reform in several countries at once. Indeed, there is a “fallacy of composition” in the current approach: The countries in need of serious adjustment and improved competitiveness include the whole of Southern Europe and France, and jointly account for more than one-half of eurozone GDP. True, competition for investment is an incentive to act. But macroeconomic and financial interdependence may render success elusive if reforming countries face an adverse regional environment of stagnating or falling demand.
It is one thing to believe that governments act only under pressure, and that societies accept reforms only if they believe that there is no other alternative; it is quite another to believe that adjustment and reform will proceed if all of Southern Europe is struggling with recession. Keeping Southern Europe on a short leash would be a more credible strategy if accompanied by a growth programme for the entire eurozone. And, at this stage, such a programme is nowhere in sight.