Salvation seeking Eurozone statesmen met in Brussels on February 11 to continue the three-year debate on the twin devils of the banking and sovereign debt crises.  Wolfgang Franz, the Chairman of Chancellor Angela Merkel’s council of economic advisors, came up with a simple analogy “if the crisis is a marathon, we’ve got two thirds of the course behind us. But the last third is always the hardest.” Is the crisis almost over? Well, it ultimately depends on our understanding of the crisis itself. Until the third quarter of 2012, most officials blamed the Eurozone’s predicament on fiscal mismanagement in the PIGS (Portugal, Ireland, Spain, and Greece) countries. While “austerity” remains the main prescription for mistrusted member states, the “troika” increasingly recognizes the need to address deeper institutional faults in the monetary union.  Two-thirds of the way in or not, Franz has one thing right – the run will involve crucial structural changes if EMU (European Economic and Monetary Union) racers are to reach the finish line.

Image courtesy of Chris Goldberg, © 2012, some rights reserved.

Image courtesy of Chris Goldberg, © 2012, some rights reserved.

An experiment: The Monetary Union

Fiscal mismanagement by profligate governments and the spill over of the 2008 subprime crisis allowed deeper institutional issues within the EMU to trigger the recession of 2009. The Eurozone crisis owes its nature to ineffective economic governance at the supra-state level, with necessary elements of political union missing in the context of escalating monetary integration in the 2000s. The monetary union exacerbated the existence of multiple equilibria and competitive differentials across member states by removing traditional automatic stabilizers at the national level. One can therefore ascertain there was a silent balance of payments crisis – the accumulation of imbalances at the disadvantage of the least competitive, a peripheral economy – prior to the contagion of the sovereign debt crisis. Without an operator to deal with fiscal management in the Eurozone, uniform interest rates enhanced business cycle divergences across Member States. Widespread differentials in inflation, relative labour costs, and prices resulted, and ultimately created deep-set current account differences between the South and North.

The solvency crisis stems from the Eurozone’s susceptibility to market distrust. In the absence of a mechanism to remove risks of default on government bonds, financial markets acquire the capacity to trigger liquidity crisis when signs of recession surface. When Ireland, Portugal, and Spain lost market confidence, investors began selling government bonds en masse; this naturally raised interest rates to unsustainable levels and brought on actual risks of default. These trends generated sudden liquidity shocks, with outflows of euros moving from the PIGS countries to “safe” Northern Member States. Actual debt-to-GDP ratios were equally high in countries across the North and Southern hemispheres; thus negative market sentiment harboured a self-fulfilling insolvency crisis for “bad equilibrium” countries.

Two-thirds of the way: “double-disparity”

With subsiding risks of a Eurozone break-up, financial market conditions gradually improved in the third and fourth quarters of 2012. What remains worrying, however, are weaker signs of improvement in the real economy. Austerity programs in the PIGS countries may have decreased “tail risks” in the short term, with the headline deficit in the Eurozone falling to 3.5% of GDP in 2012, but continued deficit reduction at the aggregate level depends on Europe’s prospects for future growth.  The upward revision of debt ratios in 2013 is primarily linked to the “snowball effect”, especially to the component of negative growth in real GDP. In light of declining domestic demand and an unemployment rate that rose to a staggering 11% in the Eurozone, downside risks to a sustainable recovery remain high.

Europe currently faces a “double-disparity” on two accounts – while financial markets showed an upturn towards the end of the fiscal year, the final quarter of 2012 saw real GDP in the EU shrink by 0.5%, and the euro area further contracted by 0.6%. The European Central Bank (ECB) has nevertheless made a tremendous effort in resolving the banking sector crisis. Draghi’s Long Term Refinancing Operation (LTRO) led to a flood of liquidity in the EU banking system, decreasing short-term interest rates and producing a positive immediate effect on sovereign debt markets. While Draghi’s policies created a buffer against the risk of liquidity shortage in the short term, loading banks with sovereign debt places them at a greater risk in case of a downturn. The ECB’s decision to become ‘lender of last resort’ through the OMT triggered the financial turnabout in mid-2012. For one, it made a crucial psychological statement, it showed that EU institutions are ready to “do whatever it takes to save the euro”, and more importantly, it instilled greater trust in Eurozone institutions. The ECB’s OMT program serves to re-design economic governance in the Eurozone, and is likely to have lasting effects on the centralization of monetary policy in the region.

A one-sided financial turnabout, however, is insufficient in generating real growth. Uncertainty prevails in the Eurozone, with banks unwilling to let go of tight lending conditions to firms and households. Moreover, higher growth differentials across Member States create further uncertainty towards the Eurozone. The ”uncertainty shock” is accountable for low credit growth and falling aggregate demand in the Eurozone. Output gaps lead to lower levels of inflation and higher unemployment, thereby threatening a double-dip recession.

Supra state emerging: A Faustian bargain

The EMU remains a fragile and incomplete construction because of the absence of a political union, comprising of a more centralized monetary and fiscal authority. The “last third of the marathon” will make for a difficult run for “the troika” because it must persuade national governments to increase the EU budget and cede increasing elements of their sovereignty. In the medium to long term, the troika should continue implementing proposals made by the Single Market Act II, and develop mechanisms that manage macroeconomic imbalances across Member states. Crucial steps towards achieving political union have recently been made. 2013 brought the Eurozone’s fiscal pact, ratified on December 21, into action and the Council plans to set up the single supervisory mechanism (SSM) in the first quarter of this fiscal year. The Eurozone needs to strengthen its set of supervisory bodies – improved economic coordination will diminish ‘uncertainty shocks’ and greater support for the Europe 2020 strategy will bolster Europe’s competitiveness.  Austerity will remain the dominant discourse in aggregate macroeconomic policy; Eurozone leaders must therefore brainstorm non-conventional means for growth generation.  The compact for growth and jobs, which provided €120 billion for investment in 2012, provides a model for collective projects that can fund sustainable and inclusive growth in Europe.