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[Last year, European Central Bank President Mario Draghi declared Mission Accomplished—that “the darkest clouds over the euro area [have] subsided.” But suddenly, it seems like this week’s electoral stalemate in Italy has thrown all such talk into question. Instability in Italy is a real and immediate threat, with either a minority government or a coalition with quarreling ministers, or even a new election if no government will be formed in the coming days.
While an Italian bond auction on Wednesday went off with relative calm, though at a significantly higher borrowing rate than before, the Italian political stalemate puts the European Monetary Union at grave risk. Political uncertainty may lead to accelerated capital outflows from Italy—a situation that would be extremely difficult to handle give the size of the Italian financial sector. Draghi is prepared to save the euro, but he can save Italy only if there is a functioning Italian government which requests a bail-out from Brussels and complies with all requirements—again, something which is not very likely given the election results. Unfortunately, there is only a short leap from politics to bond markets and Europe’s broader economy, as I have written in the Spring issue of World Policy Journal.—Zsolt Darvas]
By Zsolt Darvas
BRUSSELS—High unemployment, bleak economic outlook, high public and private debts, dysfunctional banks, weak competitiveness, and an unfavorable external environment are just a few of the challenges facing southern members of the euro zone. Despite these hurdles, the ever-optimistic European Council and other leaders said in January that the euro crisis had bottomed out. Herman Van Rompuy, the president of the European Council, proclaimed, “The worst is behind us, in particular the existential threat to the euro.” Then there was Mario Draghi, president of the European Central Bank (ECB), who declared that “the darkest clouds over the euro area [have] subsided.”
Certainly, market pressures have eased significantly since late July 2012, when Draghi delivered his remarkable “whatever it takes” speech, pledging to use every means available to a central banker to stabilize the euro, at least within the mandate of the ECB. And he said that to the extent that government bond yields are too high—not because of the risk of default or low market liquidity, but due to speculation over a possible exit of some country from the euro zone or an end to the euro entirely—they fall within the mandate of the ECB. Since then, Italian and Spanish bond yields have fallen, and the credit default swap spreads of their non-financial corporations have narrowed—a prime measure of confidence in a nation’s corporate system. At the same time, stock prices have risen throughout Europe; deposits have started to return to Greek and Spanish banks; reliance on ECB funding of European banks has been reduced, which likely signals some normalization of the euro area financial markets.
The improvement in financial stability is real, but the clear analogy, unfortunately, is to President George W. Bush, who in 2003, stood on an aircraft carrier beneath a banner that read, “Mission Accomplished,” only two months into an Iraq war that would last another decade. The dark clouds of euro crisis are hardly behind us.
BETTING THE EURO
The improvement in market sentiment is likely supported by a number of factors. Most importantly, market participants, losing money betting against the euro may have learned that facing an abyss, European policymakers always come up with something to save the euro, even if only for a few months. Indeed, European leaders may continue to behave this way, should the euro face a renewed threat.
There was also significant progress in building new initiatives in the euro area in 2012. Draghi’s “whatever it takes” speech was followed by the launch of Outright Monetary Transactions (OMTs)—the unlimited purchases of government bonds of all euro member states that meet the conditions of a financial assistance program. Integration of banking oversight started with a decision to centralize supervision of major banks. The treaty on the euro area’s permanent rescue fund, the European Stability Mechanism, was ratified. And a large number of reforms aiming to more strictly control fiscal accounts of euro area member states and their economic policies came into force. While it may be appropriate to question whether these are the proper responses to the euro crisis, the progress is undeniable.
Finally, we saw the beginnings of the adjustment of trade imbalances—the deficits of southern euro members declining in tandem with German surpluses vis-a-vis euro area partners. The export performance is now strong in Ireland, Spain, and Portugal, while labor costs have fallen.
Less clearly visible, however, is that the fundamental problems of the southern member states remain. While growth is weak everywhere in the euro area, the outlook is particularly gloomy in southern Europe. Unemployment rates continue to skyrocket, reaching 25 percent in Greece and Spain, while the jobless rate of youths exceeds 50 percent. About every second young person who wishes to work cannot find a job. Social unrest, already high in Greece, is on the rise in other southern euro members.
At the same time, public debts are high and calls for further significant fiscal adjustments (in the form of expenditure cuts and tax increases) are likely to depress demand, even if the pace of such adjustment is allowed to slow. Private debts are also high. Moreover, the collapse in output as a result of reduced consumer demand and available credit, accompanied by rising unemployment has led to widespread bankruptcies, causing further losses to the banking sector, which financed many of these companies in rosier times. It is getting to the point where banks cannot serve their main role of providing credit even to viable companies. In Spain, loans to non-financial corporations declined 18 percent from late 2008 to late 2012, but factor in inflation and the real decline in credit is 25 percent. The European financial landscape is bank-dominated with only a minor role for the securities market. In Spain, some 99 percent of credit to non-financial corporations comes from banks, barely 1 percent from securities markets. Issuing corporate debt cannot come close to compensating for the drop in bank lending. All of these factors are set to depress domestic demand in the foreseeable future.
As for external demand, the sectors producing goods and services for export are struggling in southern Europe. Their share of the total economy is low—about 10 to 14 percent of GDP in contrast to more than 20 percent in Germany and Ireland—and their competitiveness is weak. Wages simply grew too much, too fast for years before the crisis. This feeble southern export sector faces modest demand inside the euro area and an appreciating euro exchange rate, which makes exports outside the euro area less profitable. The appreciated euro is due partly to the improvement in euro area financial stability, and partly to the ECB’s rather conservative policies at a time when other major central banks, like the U.S. Federal Reserve, the Bank of England, and more recently the Bank of Japan (giving way to pressure from the recently elected Prime Minister Shinzo Abe) engage in massive quantitative easing.
[To read the rest of this article from the forthcoming Beyond Borders issue, click here.]
Zsolt Darvas, a research fellow of the Bruegel Institute in Brussels and the Institute of Economics of the Hungarian Academy of Sciences, is an associate professor of economics at Corvinus University of Budapest.
[Photo courtesy of Cesar]