A little more than a year ago, in the summer of 2012, the euro zone, faced with growing fears of a Greek exit and unsustainably high borrowing costs for Italy and Spain, appeared to be on the brink of collapse. Today, the risk that the monetary union could disintegrate has diminished significantly – but the factors that fuelled it remain largely unaddressed.
Several developments helped to restore calm. European Central Bank President Mario Draghi vowed to do “whatever it takes” to save the euro, and quickly institutionalized that pledge by establishing the ECB’s “outright monetary transactions” program to buy distressed euro zone members’ sovereign bonds. The European Stability Mechanism was created with €500-billion to rescue banks and their home governments. Some progress has been made on a European banking union. And Germany has come to understand that the euro zone is as much a political project as an economic one.
Moreover, the euro zone recession is over (although five periphery economies continue to shrink and recovery remains very fragile). Some structural reform has been implemented and a lot of fiscal adjustment has occurred. Internal devaluation has occurred to some extent (in Spain, Portugal, Greece and Ireland, but not in Italy or France), thus improving external balances. And even if such adjustment is not occurring as fast as Germany and other core euro zone countries would like, they remain willing to provide financing, and governments committed to adjustment are still in power.
But beneath the surface calm, the euro zone’s fundamental problems remain unresolved. For starters, potential growth is still too low in most of the periphery, given aging populations and low productivity growth, while actual growth will remain below 1 per cent for the next few years, implying high unemployment rates.
Meanwhile, levels of private and public debt are still too high, and they continue to rise as a share of GDP, owing to slow or negative output growth. This means that the issue of medium-term sustainability remains unresolved.
At the same time, the loss of competitiveness has been only partly reversed, with most of the improvement in external balances being cyclical rather than structural. The severe recession in the periphery has caused imports there to collapse, but lower unit labour costs have not boosted exports enough. The euro is still too strong, severely limiting the improvement in competitiveness needed to boost net exports in the face of weak domestic demand.
Finally, while the fiscal drag on growth is now lower, it is still a drag. Its effects are amplified in the periphery by an ongoing credit crunch, as undercapitalized banks deleverage by selling assets and shrinking loan portfolios.
The larger problem, of course, is that progress toward banking, fiscal, economic and political union – all essential to the euro zone’s long-term viability – has been too slow. Indeed, there has been no progress whatsoever on the latter three, while progress on the banking union has been limited. Germany is resisting the risk-sharing elements of such a union: common deposit insurance, a common fund to wind up insolvent banks, direct equity recapitalization of banks by the ESM.
Germany fears that risk-sharing would become risk-shifting, and that any form of fiscal union would likewise turn into a “transfer union,” with the rich core permanently subsidizing the poorer periphery. At the same time, the entire regulatory process for the financial sector is pro-cyclical. The new Basel III capital-adequacy ratios, the ECB’s upcoming asset-quality review and stress tests, and even the European Union’s competition rules (which force banks to contract credit if they receive state aid) all imply that banks will have to focus on raising capital – and thus not providing the financing needed for economic growth.
Moreover, the ECB is unwilling to be creative in pursuing policies – like those embraced by the Bank of England – that would ameliorate the credit crunch. Unlike the U.S. Federal Reserve and the Bank of Japan, it is not engaging in quantitative easing; and its “forward guidance” that it will keep interest rates low is not very credible. On the contrary, interest rates remain too high and the euro too strong to jump-start faster growth.
In the meantime, austerity fatigue is rising in the periphery. The Italian government is on the verge of collapsing, the Greek government is under intense strain as it seeks further budget cuts and the Portuguese and Spanish governments are having a hard time achieving even the looser fiscal targets set by creditors, while political pressures mount.
And bailout fatigue is emerging in the core. Populist parties are pushing against bailouts for banks and governments alike. In Germany, the next coalition government looks set to include the Social Democrats, who are pushing for a bail-in of the banks’ private creditors, which would only exacerbate balkanization of the euro zone’s banking system.
So far, the grand bargain between core and periphery has held up: The periphery continues austerity and reform while the core remains patient and provides financing. But the political strains may soon reach a breaking point, with populist anti-austerity parties in the periphery and populist anti-euro and anti-bailout parties in the core possibly gaining the upper hand in next year’s European Parliament elections.
If that happens, a renewed bout of financial turbulence would weaken the fragile recovery. The calm that has prevailed in financial markets for most of the past year would turn out to be a mere temporary respite between storms.
Nouriel Roubini is chairman of Roubini Global Economics and professor of economics at the Stern School of Business, New York University.