Economic challenges ahead for Europe
By Gene Frieda
Global strategist for Moore Europe Capital Management
Europe's great success in 2012 was to avoid becoming another of
history's failed monetary unions. European Central Bank President
Mario Draghi's actions prevented a market meltdown and bought
European leaders time to deliver on political and institutional
reform. But have political leaders again chosen to muddle through,
rather than meld a resilient strategy?
To be sure, few envisioned the degree of compromise and integration
that was achieved during the acute phase of Europe's financial
crisis. Control mechanisms that theoretically infringe on
sovereignty are now in place for national budgets and, soon, for
the 150 or so largest European banks. Creation of the European
Financial Stability Facility and its successor, the European
Stability Mechanism (ESM), provide an important financial backstop
for smaller countries that are destabilized by external shocks,
Project Syndicate wrote.
But the real game changer has been the ECB's creativity in
designing ways to prevent the sudden insolvency of banks and
governments. While it might take military expertise to learn all of
the acronyms created in the last three years, the LTRO (long-term
refinancing operation) and OMT (outright monetary transactions)
will be remembered as the ECB's twin bazookas.
Nonetheless, while bazookas may win battles, they do not win wars.
This is particularly true in finance, because markets, politicians,
and citizens adapt to changing circumstances. The success of 2012
was to end the acute phase of the crisis; but its chronic features
persist.
Of course, capital markets have reopened to large corporations and
many European banks. Europe "feels" better. But it is rarely wise
to judge financial health by one's borrowing costs, which can
change abruptly. Together with other major central banks, the ECB
has ensured that any doubts about solvency have been temporarily
put to rest with a tsunami of liquidity.
The European Council's decisions in December defined the vision
outlined by Draghi last July. But European leaders rejected even
limited fiscal risk-sharing in the form of temporary unemployment
contracts. Banking union was left looking like a stool with one
sturdy leg (common supervision), a toothpick (common resolution),
and no third leg (common deposit insurance) whatsoever. The
creditor countries, seeking to define legacy assets narrowly in
order to minimize their losses, are emasculating the most important
vehicle for breaking a vicious feedback loop between sovereigns and
banks - direct bank recapitalizations with ESM funding.
The most creditworthy European countries still believe that a
monetary union can work only if every member is committed to
responsible macroeconomic policies that avoid the accumulation of
imbalances. There is a powerful logic to this argument, given that
a union in which some states' conservative taxpayers always pay for
others' profligate spending cannot endure politically.
Nonetheless, in a world of fast and free capital flows, Europe's
leaders have failed to grasp that control mechanisms cannot prevent
the build-up of imbalances. After all, one of Europe's great
strengths has been to bind together large and small, rich and poor,
and labor-intensive and services-intensive countries. Despite their
differences, all are subject to the same monetary policy and, at
least according to the current vision, to very similar (and rigid)
fiscal policies.
That vision involves miniscule fiscal transfers to help buffer the
asymmetric effects of common shocks. Instead, a group of regulators
in Frankfurt and bureaucrats in Brussels will catch imbalances
before they become severe.
For Europe's periphery, this minimalist vision of fiscal
integration means one thing: government and private debt will need
to fall to levels associated with the AAA-rated economies, because
external financing for persistent imbalances cannot be assured.
Even if monetary policy remains extremely accommodative (despite
being inappropriately loose for some of the healthy economies),
this implies decades of stagnation for the periphery and the
transformation of high long-term unemployment into a lost
generation of chronically jobless youth.
Acute crises rarely produce political movements demanding change.
On the contrary, fear prevails and the status quo - in this case,
European integration - wins, as it has since 2010 in Greece, Spain,
Portugal, Ireland, and the Netherlands. Rather, it is the chronic
phase of the crisis that will breed change, as fear gives way to
anger and politics moves to extremes.
Japan might seem to provide a counter-example. After all, the
country has been in a chronic state for nearly a quarter-century,
yet it took almost two decades to kick the Liberal Democratic Party
out of power (and now it is back). But the decline in Japan's per
capita GDP has been gradual and, importantly, unemployment has
remained below 5.5%, compared to just under 20% in Europe's five
worst-hit periphery economies.
Much of the blame for Japan's malaise lies with its politicians'
unwillingness in the early 1990's to address a banking sector laden
with bad real-estate debt. The lesson of that and other banking
crises is that speedy diagnosis and treatment go a long way toward
determining whether a country's exit from the acute phase of crisis
leads to a protracted chronic phase or a rapid return to healthy
growth. Japan could rely on its large stock of domestic household
savings to cushion the corporate sector's adjustment and to finance
massive fiscal spending, with government debt now around 230% of
GDP.
This strategy cannot be replicated in Europe. Chronic adjustment is
not sustainable, given localized pockets of unemployment above 20%,
minimal recourse to fiscal policy to smooth adjustments, and a
lender of last resort that is constrained by its members'
preferences. Moreover, Europe does not have the social strength to
cope with such a strategy, owing to its lack of cultural
homogeneity and large, often marginalized immigrant
populations.
The prescription is clear: fix the banks, share the burden of past
mistakes between countries, and replace the OMT with an equivalent
bazooka by turning the ESM into a rescue fund that can cope with
problems large and small. The planned shift to a bail-in regime for
private creditors and political acceptance of default for errant
sovereigns will probably end fiscal profligacy.
But Europe's saga will not end there. Having escaped markets'
wrath, politicians will now face that of their voters.
Copyrights: Project Syndicate