EUROZONE CRISIS: Survival of the fittest
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EUROZONE CRISIS: Survival of the fittest

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European leaders have to take decisive action to show they can handle the crisis – or resign themselves to the inevitable break-up of the euro

Even compared with the rollercoaster ride that eurozone financial markets have endured since Greece’s problems first emerged in 2009, the last month was particularly awful.

Yields on bonds of the weaker member states soared, stock markets slumped, and surveys of the real economy show that activity and confidence took a beating.

But while markets have stabilized recently, political leaders face a busy month or two if they are to prevent the worst fears of a euro break-up becoming true. “EU leaders are facing a dangerous combination of austerity exhaustion, bailout fatigue and possible recession,” says Sarah Hewin, head of research for Europe at Standard Chartered.

Even supporters of the euro project are getting exasperated at the failure of the zone’s leaders to address the problems. “It is my view that Europe’s crisis is on the verge of becoming the world’s crisis,” says Barry Eichengreen, professor of economics at the University of California, Berkeley.

The lack of growth has become a real issue for policymakers, as economic recovery was a key ingredient of the fiscal rescue plans put in place. However, with euro area growth in the three months to June at an anaemic 0.2% and signs of a further slowdown in the third quarter, the real economy looks set to be a bane rather than a boon.

Joseph Stiglitz, the Nobel laureate and former chief economist at the World Bank, says fiscal austerity – tax hikes and spending cuts – to reduce budget deficits is the wrong course. “More austerity for Greece is not the answer, more austerity for Spain is not the answer as 40% of young people are unemployed, and more austerity will lead to higher unemployment,” he says.

“On their own they can’t start growing again, and they can’t get out of their problems without growth. The problem is, what’s the alternative?”

Eichengreen takes a more nuanced view: austerity is still the right policy for countries like Greece, Portugal, Spain and Italy that have “serious” debt problems and cannot afford to take on more debt. “It is really important to be clear who we are talking about: if you are talking about Germany and northern Europe the situation is very different,” he says.

MORE MONEY?

But speaking on the sidelines of the 4th Lindau Meeting of Economic Sciences in Germany, Stiglitz says the answer is more money rather than more cuts. In his view the three options are a top-up of the European Financial Stability Fund (EFSF) by governments, an injection by the ECB, or the creation of a Eurobond.

Eurozone leaders bolstered the E440 billion EFSF at their July summit to allow it to extend finance to avert a default rather than deal with the consequences, and to buy bonds in the secondary market to lower yields. According to Holger Schmieding, chief economist of the German bank Berenberg, the idea of any further capitalization of the facility is “off the table”.

“They are capitalized enough to deal with Spain, but they do not have the resources to deal adequately with Italy,” he says. “Increasing the EFSF is not on the table, and I am not convinced it would be a good option. It would either be a modest increase, which means a lot of noise about something not very substantial, or it would be a very serious increase.”

A substantial increase would require approval by the German parliament. “The more we ask of the German parliament, the bigger that ‘if’ gets,” he says.

The Bundestag will vote next week on whether to approve the June strengthening of the EFSF. Schmieding believes it will say yes because the consequence of a no vote would be the “collapse of Europe and the worst German recession in living memory”.

It is this realpolitik that has enabled leaders to muddle through with their response to the series of crises, much to the frustration of the markets.

Robert Mundell, the economist who won the Nobel for his work on optimal currency areas that paved the way for the euro, believes politicians will find a solution. “We are in the early middle of a very big crisis because nothing has been done yet to convince the markets that there’s been a fundamental change in Europe,” he says.

NO FISCAL DISCIPLINE

The problem for Mundell is a lack of fiscal discipline that allowed countries with low per capita incomes to embark on spending sprees and guarantees of entitlements to their citizens. “Overspending is the major issue, and there has to be a correction of that – and that has to be more than just an adjustment of budgets,” he says. “They have to bite the bullet and cut back on some entitlements such as pensions programmes and age of retirement.”

The problem is that Italy and Greece seem to be backtracking on existing commitments. The “troika” of the IMF, EU and ECB pulled out of talks with Greece after it emerged the beleaguered nation would miss its deficit and growth targets.

Greek 10-year bond yields last week surged to an astonishing 20 percentage points above Germany’s – a sign markets are betting on default. German economy minister Phillip Rosler has called for an “orderly insolvency”.

Schmeiding says it is not the amounts involved that are important but the signals they send. “Where politicians are sending signals to the market, they need to make sure they get the signals right,” he says.

Mundell believes the eurozone laggards have until the end of next year to put their houses in order. “A crisis like this will not get solved quickly,” he says. “They have a few months to play with, but it could come up big if they don’t start to show a clear track and take steps to mend it. They have got to show they can manage the crisis.”

REFORM PLANS

While these moves are necessary for the short-term survival of the euro, there is still an ongoing debate over the long-term reform of the eurozone. Mundell points out that the creation of a single currency without some sort of fiscal consolidation was a mistake because it took away the vital “warning signal” of devaluation without replacing it with a mechanism to prevent ballooning budgets.

“Responsibility for that balance has to rest with a central group or with individual members. In Europe it rests with the individual members,” he says, adding that leaders need to start looking at moving towards more union.

“Here again is a big problem because the eurozone can go ahead in a big way without de facto creating a two-stage Europe, which no one really wants, because they see that as a tendency to become more and more permanent.

“But the euro area can’t be prevented from taking the steps to save the currency and the solvency of the entire area.”

But the longer it takes to get political resolve, the higher the cost is going to be, Stiglitz says. “The only people benefiting from the delay are speculators – the very people who European politicians tend to blame for their problems. Europe is providing the framework for the volatility off which they live.”

FISCAL UNION

Holger Schmieding says overt moves towards fiscal union will expose the eurozone to further division and away from a unified response. “We are step by step getting closer to something like fiscal union by having more control by the strong countries over the weak countries,” he says. “Fully-fledged fiscal union would mean Germany guarantees everything and would therefore ask to be able to dictate almost everything. That is politically unlikely from all sides concerned.”

This is the reason why many experts believe Eurobonds have encountered such hostility from Germany, which has effectively to underwrite debts of all member states to secure a triple-A rating.

“I would rather have more of the current muddling through, even though it’s not pretty, than have the ultimate fiscal union that I consider would be at least as explosive as anything we could imagine at the moment,” Schmieding says.

Eichengreen agrees, saying long-term issues such as fiscal union, Eurobonds and better surveillance only distract from what he identified as “urgent imperatives”.

“The urgent imperatives are: to restore confidence in the banking system, to get growth going again and give Greece some breathing room to relax its fiscal targets. Stop talking about Greece and do something about it,” he says.

His recipe is in line with the recommendations that IMF managing director Christine Lagarde made in her speech last month at the Jackson Hole conference. She focused on the need for bank recapitalization, bringing in private capital first but then using the EFSF or other European-wide funding to recapitalize banks directly.

Eichengreen backs Lagarde’s new approach, saying she could go further and create a credit facility to enable countries such as Greece to reduce their debts at a lower cost than having to issue zero-coupon bonds. However, he adds, she will need the support of the US and Asian countries. “I think it is over time for the IMF to stop bowing to the wishes of European governments,” he says.

EURO BREAK-UP

But overarching all these debates is the growing fear that the ultimate result may be the break-up of the euro. The increased focus on Germany’s complaints raises the question of whether the eurozone’s largest member might decide to leave the euro rather than face the risk of underwriting the weaker nations.

“A consensus is emerging among economists that it would be better for contractual complexity for Germany to leave [the eurozone] than for Greece to leave,” says Stiglitz. While it is hard to “unscramble the scrambled egg”, it would be easier for Germany to cope with a sharp appreciation of a new D-mark than for debt-laden Greece to deal with a depreciating drachma.

“If it’s going to be the end of the euro, people should start to think about how it should be done in the most orderly way and with the least perturbation to the people of Europe,” he says.

But he does not believe the euro should break up, saying that while keeping the euro intact will be costly, the costs are outweighed by the havoc wrought by a break-up. “You can lose money and actually have a political venture that has a future, or you can lose money and watch an idea that had great hope, especially for the youth, go down the drain,” he says. “It seems to me that the issue is how do you keep the euro alive.”

Mundell agrees, saying he rejects warnings from figures such as former European Commission president Jacques Delors that the euro is “on the verge” of collapse. “I don’t agree the solution is the end of the euro as that would create more problems than it’s going to solve,” he says. “The euro isn’t the problem.”

Perhaps the best indicator of the way that debate has changed is the attitude of Eichengreen, among the strongest supporters of the euro project in the US. “We could have an interesting academic debate about whether creating the euro was a mistake ... and increasingly the evidence does point in that direction,” he says.

“But sometimes you have to accept your mistakes and make the best of them because the alternatives are even worse.”

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