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The eurozone faces a defining choice. The single currency block must come to terms with the new normal: going back to business as usual is not an option

 

The eurozone will soon turn 12 years old, though it’s not yet clear whether the anniversary will be one to celebrate. Policymakers and politicians across the bloc face a fundamentally altered post-crisis universe, in which they must not only come to terms with the ‘new normal’ but also guide the single currency through it, either by embracing the EU mantra of ‘ever-closer union’, or ensuring alternative tools exist to stop gaps in the monetary union from widening. “The crisis has laid bare some fundamental gaps in economic governance that not only placed the euro area at great macroeconomic and financial risk, but may also hamper its long-term growth prospects,” IMF managing director Dominique Strauss-Kahn said mid-September. “Now, in the wake of a major economic crisis, the euro area faces a defining choice: going back to business as usual is not an option.”

The turbulence started late last year. Fitch, Standard & Poor’s and Moody’s downgraded Greek sovereign debt after the country’s new government revealed that the budget deficit was 12.7% of GDP. This was more than twice the level previously reported, and over four times the limit imposed by the Stability and Growth Pact, the fiscal rules by which single currency members must abide.

The resulting crisis caused spreads between Greek and German government 10-year bonds to reach record highs of over 900 basis points, and credit default swaps on Greek bonds to soar; it also led to fraught negotiations between the EU, European Central Bank (ECB), IMF and Greek government over sovereign support. Contagion ensued. Investors rushed to sell Italy, Ireland, Portugal and Spain’s sovereign debt.

The question of a eurozone break-up was even raised, along with the realization that no legal framework for this to occur was in place.

On May 9 eurozone finance ministers agreed a E750 billion bailout package, including EU and IMF loans being made available, and the creation of the European Financial Stability Facility (EFSF), to provide a funding backstop for any member state in financial difficulties.

Like most steps towards fiscal unity in the bloc, it met opposition, this time from Slovakia, where the parliament last month ruled against contributing E816 million to the E110 billion bailout fund for Greece.

“These instruments are designed as a temporary response to these exceptional circumstances,” EU commissioner for economic and monetary affairs Olli Rehn tells Emerging Markets. “While the European Commission is considering the merits of establishing a more permanent crisis resolution mechanism, I would not overload the discussion by making any references to some kind of European IMF.”

REBALANCING ACT

Moves toward fiscal unity come at a time of economic uncertainty. In September, the commission revised upwards its 2010 GDP forecasts to growth of 1.8% in the EU and 1.7% in the euro area. “This aggregate picture masks uneven developments across member states, confirming the commission’s expectation of a multi-speed recovery within the EU,” it said at the time.

“This is not surprising given differences in the scale of adjustment challenges and ongoing rebalancing within the EU and euro area.”

This process will be at the top of the EU institutions’ agenda again in 2011. “We do need to make progress in trying to solve how we can address the macroeconomic imbalances – some countries such as Germany have a very competitive position, and you can’t attack competitiveness, but they also have the instinct to save money when times are hard,” Sharon Bowles, MEP and chair of the European Economic and Monetary Affairs Committee, tells Emerging Markets.

“So in health terms, it’s a bit like they’re doing the kind of things that you would do if you were ill. But they’re not ill. And that tends to create more tension within the eurozone.”

Closer unity is a double-edged sword. As well as providing a safety net, it can also mean – as per Slovakia’s objection to the EFSF – that a poorer country ends up bailing out a richer one.

“The chance of a break-up has increased due to the fact that the eurozone countries have considered it part of their obligation to bail out a failing member,” says Hal Scott, professor of international financial systems at Harvard Law School. “This bailout obligation has already come at considerable economic and political cost. Further, it increases the likelihood of countries overspending in the future.”

There’s another route eurozone members can take to balance out differences. “Within the eurozone there are two choices – you can either say, let’s go for more integrated fiscal union, which is what some people want, but I don’t believe as yet that the majority wants that,” says Bowles. “If you’re not going that far, you have to try and recreate some of the tools for managing the economy that you’ve lost because you’re in the eurozone.”

Options for countries to manage their own economy include compulsory savings, tax increases (or better collection of existing ones), making banks hold certain levels of capital, or adjusting the risk ratings on the loans that are given on any area where a bubble seems to be emerging.

This would also require a greater degree of eurozone unity, however, as no country would want the disadvantage of being the first to move in the run-up to the recent crisis. Any changes must be made in harmony with the existing framework: as ECB president Jean-Claude Trichet said recently: “We are the only central bank which is transforming, by virtue of its own activity, the economy under its jurisdiction.”

NEW PENALTIES, NEW RULES

Moreover, any new rules would have to be enforced – along with existing ones. Since the introduction of the single currency, no member state has ever been punished for breaking the Stability and Growth Pact, as political considerations have always prevented member states from enforcing the sanctions.

Options for beefing up the pact are high on the agenda in Brussels.

The European Commission has proposed eurozone members should set aside 0.2% of their GDP if they run up too much debt. A fine would be levied if they fail to bring their debt back under a certain level. The proposals also cover competitiveness and would be applied quasi-automatically, meaning members would have to vote not to apply them, the reverse of the current situation.

“An important lesson we draw from the past is that the application of the fiscal rules, including procedures and sanctions, should be de-politicized and quasi-automatic,” Jürgen Stark, member of the Executive Board of the ECB, tells Emerging Markets. “Broadening the variety of sanctions including political sanctions, such as losing voting rights and applying graduated sanctions as soon as countries go off track, could also help to make the rules more binding.”

He also calls for an independent body to assess the fiscal positions of countries and provide policy recommendations.

However, this still may not be enough to ensure equal treatment for all member states when their economies vary so much in size. “The pact might be better enforced against smaller countries, but I doubt it would ever be enforced against France or Germany, who have violated its rules in the past,” Harvard’s Scott says. “Fiscal unity is the only real solution.”

But doing nothing is not an option.

Ireland revealed on September 30 that the state rescue of Anglo Irish Bank, which hit the rocks when the country’s property bubble burst, could cost as much as E34.3 billion. This, plus the cost of helping other banks, such as Allied Irish, could push Ireland’s public deficit to 32% of GDP this year. That would be the largest deficit for a eurozone member since the introduction of the single currency.

This comes amid growing concern over soaring levels of sovereign debt more generally. The spreads between Greek and German debt have been creeping up and are close to their May levels.

“Greece has made progress in putting its fiscal policies back to order. So far these efforts have not been reflected in the yields of Greek government bonds,” Rehn says. “Spreads of several European government bonds have widened over the summer, due to a generalized flight to quality amid investor concerns related to the stability of the global economic recovery.”

In its September forecasts, the European Commission revised its expectation for 2010 German annual GDP growth to 3.4%, while it expects Spain to contract by 0.3% over the same period.

As Europe’s biggest economy, Germany will play a key role in the recovery – or lack of one. Germany’s GDP grew 2.2% in the second quarter from the first, fuelling confidence about the rebound, but this may not last. The Centre for European Economic Research, ZEW institute’s sentiment indicator for Germany dived 18.3 points to minus 4.3 points in September, and in July German exports dropped for the first time in three months. As the world’s second-largest exporter, sales abroad are key for Germany and therefore Europe. This means the recovery there depends on the health of the US and other economies, but also on foreign exchange developments in the coming year.

“We are particularly concerned about the exchange rate of the Chinese renminbi, which remains substantially undervalued, despite the announcement of the Chinese authorities in June to move to a more flexible exchange rate regime,” says Rehn. “We see therefore the risk that the euro area may have to carry a large burden of the adjustment on the US current account deficit.”

Ultimately, the eurozone has come through the unexpected turbulence of its first sovereign debt crisis intact, with a shiny new bailout fund to show for it. Whether this proves to be the foundation of a closer economic or fiscal union that cements the currency bloc’s status, or the first of a series of fraught negotiations and fix-it solutions, is in the hand of leaders, legislators and policymakers over the coming year.

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