Is Europe Out of the Woods?

There is no doubt that the outlook for Europe has brightened since early 2012. Ten eurozone countries had just been downgraded by the ratings agency Standard & Poor’s. Economic activity was spiraling downward, while nervous investors were fleeing southern European banks. The Spanish government was about to nationalize Bankia, the country’s fourth-largest bank, but could not say where it would obtain the funds to recapitalize it. Interest rates on government bonds were racing upward.

In Greece, meanwhile, an election was approaching, amid fears that the new government would reject the country’s financing agreement with the European Union and the International Monetary Fund. At that point, the country might be forced out of the eurozone.

And what happened in Greece would not stay in Greece. Once the process of euro exit had started, there was no telling where it would stop. The general feeling was that the common currency was doomed.

In fairness, this dark prognosis was not universally embraced. My own favorite recollection of this period is from March 2012, when I shared a podium in New York with another, more famous economist. We were asked: “What probability do you attach to Greece leaving the eurozone by the end of the year?” He said 100%. I said 0%. This caused no little amusement in the audience. In the end, one of us was more right than the other.

What those forecasting the eurozone’s collapse overlooked was the commitment of elected officials and their constituents to the European project. In Greece, where tensions ran highest, Syriza, the main leftist anti-euro party, received only 27% of the vote in the 2012 parliamentary election. In the run-up to Germany’s general election later this month, the Christian Democrats and the Social Democrats have indistinguishable pro-euro positions. Alternative für Deutschland, the anti-euro party, is polling a mere 4%. It may yet win a few seats in the Bundestag; but the numbers indicate that euro-skepticism remains a fringe position.

Along with this deep and abiding commitment to the European project, there is fear of the unknown. The consequences of abandoning the euro are highly uncertain, and few European leaders are willing to go there. When push comes to shove, they are prepared to do just enough to hold the eurozone together, even if the necessary steps are economically and politically distasteful.

So what changed in the last year? First, Europe now has a true lender of last resort. In July 2012, European Central Bank President Mario Draghi pledged that the ECB would do “whatever it takes” to preserve the euro. Draghi was still new on the job, so markets interpreted his pledge as signaling the advent of a new regime.

A few days later, the ECB established its “outright monetary transactions” program, which promised potentially unlimited purchases of troubled eurozone governments’ bonds. As a result, a mad dash for the exits by investors could no longer cause European financial markets to collapse.

Eurozone member states then agreed to address their banking problems by creating a single supervisor and a mechanism for winding down bad banks. Spain conducted a systematic audit of its banking system, and €100 billion ($132 billion) of EU and IMF money was made available for recapitalization.

To be sure, there has been only limited progress in establishing the single supervisor – and no progress on the resolution mechanism. But the commitment is important. The specter of a collapse of Europe’s banks, like the specter of a self-fulfilling debt crisis, has been banished, allowing Europe’s nose-diving economies to pull up in time.

But Europe could still suffer a hard landing. The banks remain weak. Now that the European Banking Authority has finally issued new prudential rules, they can get about the business of raising the capital they need as a buffer against losses. Société Générale has moved in this direction, but few other banks have followed so far. So long as European banks remain undercapitalized and overleveraged, a sustainable recovery supported by robust bank lending is unlikely.

Nor has the debt overhang been removed. In the first quarter of this year, the eurozone’s public-debt ratio actually rose, to 92.2% of GDP. Given policymakers’ reluctance to contemplate write-downs, specifically of debt held by official lenders, governments have been forced to levy high taxes to service their obligations, in turn depressing investment. It would be better to give the European Stability Mechanism, the ECB, and other official holders of sovereign debt the haircuts that they deserve.

Doing just enough to prevent the eurozone from collapsing is not the same as setting the stage for sustainable growth. Yes, Europe’s economic performance has improved. But if policymakers fail to complete unfinished business, the prognosis will be bleak.

Copyright: Project Syndicate, 2013.
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