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Economics: An existential moment for the euro

One of the distinctive features of the post-2008 financial world is the recurrent tensions in euro-area sovereign debt markets, in clear contrast with developments in other industrial countries.

One of the distinctive features of the post-2008 financial world is the recurrent tensions in euro-area sovereign debt markets, in clear contrast with developments in other industrial countries. In the United States and the UK, for example, long-term government bond yields have trended consistently down since mid-2008, in some cases reaching unprecedented lows late last year. On the opposite side of the spectrum, an increasing number of euro-area countries are experiencing funding difficulties amidst rising sovereign spreads versus Germany, when compared to the US and the UK.

The most dramatic case is, of course, Greece, which has effectively defaulted on much of its debt. But, more importantly, sovereign tensions spread last year to bigger countries such as Italy and Spain which, together, represent as large a share of the euro-area as Germany. Sovereign tensions in the euro-area can no longer be dismissed as isolated to marginal countries. If allowed to continue, those tensions would create (and are indeed creating) an existential threat to the euro. We are witnessing a defining moment for the future of Europe and, as always in such an instance, there are major risks and opportunities for investors attached to it.

In a nutshell, the sovereign tensions in the euro-area’s periphery reflect a renewed awareness – which was absent in the pre-2007 world – of the existence of credit risks in countries that no longer control their monetary policy. Thus, even if prior to 2007 the US and the UK developed macro-economic and financial imbalances as large as (and sometimes larger than) those of the euro-area’s periphery, the possibility of resorting to the printing press reduces enormously the risk of default (although, in exchange, it raises the risk of inflation and the country’s exchange rate in the long term). The virtual absence of credit spreads among euro-area sovereign bonds in the first decade of the euro period was an abnormality. The key questions as the euro has entered into its second decade are:

1. Have spreads now widened too far, and thus represent an attractive medium-term investment proposition?


2. Or will the euro break up creating major losses for investors in the entire periphery (and elsewhere)?

The plight of the periphery

Fundamentally, peripheral countries need to tackle two interrelated macro-economic problems: a high level of (public and/or private) debt and the accumulated loss of external competitiveness. Correcting them requires, respectively, a prolonged period of deleveraging and of low wage and price inflation. The former is necessary to reduce debt to more sustainable levels; the latter is needed to shift productive resources from satisfying domestic demand towards exports. The problem is that, without a sufficiently accommodative monetary policy, both adjustments interfere with each other: Low inflation makes deleveraging more difficult and potentially self-destructive, because it may lead the economy into a tailspin. This is the state that Greece is in, Portugal may be entering into, and where Italy, Spain and Ireland might find themselves in the not too distant future.

A further complication arises from the absence of a major impulse from external demand, which would soften the domestic adjustment in those countries. If Germany and other core countries were to experience a strong domestic demand-led recovery, then the periphery would at least enjoy a rapid increase in its exports, limiting the negative effect of the contraction of domestic spending. After all, the reverse happened in the pre-2007 world, when domestic booms in the periphery (and a generally strong global economy) helped Germany tackle successfully its own problem of external competitiveness created after the exchange rate appreciation of the early 1990s. Unfortunately, there are no signs, nor near-term, prospects of a strong economic recovery in Germany. German consumers remain as savings-prone as ever.

A bit of political perspective

The euro was from the beginning a political project. Its fathers conceived monetary union (EMU) in the early 1990s as a first step towards the final goal of political integration, which was deemed unfeasible at that time. They knew that a single currency without sufficient fiscal (and, hence, political) integration would run into internal contradictions – although, of course, they did not have perfect foresight to anticipate what shape these contradictions would exactly take (now, we know!). The plan was: “Once the internal inconsistencies show up, we’ll grab that opportunity to take a step towards political integration. After all, the European project always progresses in response to crises”. Indeed, EMU was itself a response to the growing problems encountered in managing different monetary policies in a world of free capital movements in a closely integrated trade area.

Today’s policymakers do not seem to have the grand vision of the early fathers of the European project. At first, they underestimated the depth of the current crisis, treating Greece as an isolated case with an “ad hoc” rescue program which is inescapably failing. Later, they tried to “ring-fence” Greece, Ireland and Portugal with rescue mechanisms that are not big enough to tackle similar funding difficulties in Italy and Spain.

Recently, however, there are some signs that, faced with a stubborn reality, European policymakers may finally be grasping that this is a “make or break” moment for the euro and the entire European integration project. Witness the bolder actions by the ECB (providing massive liquidity injections to save the banks and, indirectly, help government funding) and by governments (setting up a larger and more flexible rescue mechanism and starting to discuss, albeit informally for now, further significant steps towards fiscal integration).

At the end of the day, unless there is a rapid revival of economic growth in the periphery, the future of the euro lies in the increasing financial support (or the credible promise of it) by Germany and other core countries. Today, that support still looks half hearted, and the risk that domestic politics interfere in the future with a deeper German involvement in supporting the periphery remains high.

The ECB liquidity actions and the strengthening of the rescue mechanisms have contained the sovereign crisis but not redressed it entirely. In the past two years, investors in core countries have repatriated hundreds of billions of euros from the periphery. The challenge is to convince these investors to return to the periphery, and they will do so only when they see either economic growth returning or, while they wait for that to happen, a decisive commitment to help them by the European authorities (starting with Germany) and perhaps the IMF.

Risk and returns

There is thus a lot at stake in the Euro area and, in particular, in Italy and Spain. The consensus scenario is that the Euro area will experience a prolonged period of sluggish growth but that the euro will survive (with Greece perhaps out) and that there will be future gradual steps towards fiscal and political integration. In the meantime, the ECB will be more constructive in the face of Italian and Spanish difficulties, because they are large enough to drag the entire area down with them.

But there are more extreme, not unrealistic scenarios. In the first one, European policymakers bite convincingly the bullet by transferring rapidly more fiscal sovereignty to a central European fiscal authority and eventually issuing common Eurobonds. In this case, Italian and Spanish spreads are very attractive, and the euro’s exchange rate would likely benefit. After all, as European policymakers repeat time and again, the Euro area, taken as a whole, can boast of a much more balanced macro-economic and financial position than the United States and the UK.

In the opposite scenario, domestic political considerations in Germany or other core countries impede the deepening of EMU or the adjustment in the periphery reaches social limits. The entire periphery would precipitate into a series of defaults, probably leading to a break-up of the euro. In this event, peripheral assets plunge massively (via massive haircuts and/or large exchange rate depreciations) but also core assets would suffer (because of the end of the trade advantage inside the Euro area and of a one-time negative wealth shock).