Changes in sentiment could not have been more dramatic. In November 2011, politicians and investors feared financial meltdown in Europe as markets seemed likely to shut down ahead of an imminent record issuance by euro area sovereign and bank borrowers in the first quarter of 2012. Four months and a trillion euro European Central Bank (ECB) liquidity injection later, the same people bristled with confidence and chased risky assets again. Has the euro crisis really turned the corner, and can we now look forward to quieter times ahead? The answer is probably no.
To be sure, we have come a long way in developing a better institutional framework for economic and monetary union (EMU). When the Greek government was cut off from capital markets in early 2010 policymakers in the euro area were caught completely unprepared and had to develop crisis management techniques and mechanisms on the go. Two years on we are about to complete a new framework for fiscal policy co-ordination and surveillance as well as a permanent crisis management mechanism.
But doubts remain as to whether the new regime will really be effective when it comes to crisis prevention and management. Why should countries that flouted the requirements of the Stability and Growth Pact in the past respect the constraints imposed on them by the new system of pacts—the so-called “six-pack”— and the new intergovernmental fiscal treaty in the future?
The experience of the last two years has shown that market pressure is the most effective enforcer of fiscal discipline and structural reform. Yet the new governance regime gives markets virtually no role to this effect. On the contrary, debt restructuring in the case of Greece is dubbed exceptional and unique instead of being held up as a precedent for treating an over-indebted and insolvent country.
It remains unclear where the permanent crisis management body, the European Stability Mechanism (ESM), is to obtain its funds to fight a financial crisis when this very crisis is causing all capital markets for all borrowers to seize up. A lack of trust in the proper functioning of European Union (EU) institutions seems to have prevented the only sensible solution, that of creating a European monetary fund which, like the International Monetary Fund (IMF), would have had access to central bank credit as a measure of last resort in a financial emergency. Because of this omission, the ESM will remain incomplete and have to rely on the IMF as a final backstop in times of crisis. Europe can only hope that the other shareholders of the IMF will tolerate such a systematic role of this institution in the architecture of the EMU.
The euro area economy is expected to be in recession this year as countries try to shrink their excessive fiscal and external current account deficits. Recovery from recession will only be possible when they manage to increase their exports and reduce both domestic demand and imports. Experience with past crises suggests that this will require a depreciation of the real exchange rate. In a currency union, where nominal exchange rate realignments are out of the question, this is only possible through changes in relative prices. However, despite recession, the levels of real effective exchange rates (based on relative unit labour costs) in Greece, Italy, Portugal and Spain were recently still above their respective levels at EMU entry (ranging from +28% in the case of Italy to +5% in Portugal). Only Ireland has so far managed a drop in its real exchange rate to below its EMU entry level (by some 12%). Hence, most of the “problem” countries will have to see their unit labour costs fall further. This will probably require nominal wage cuts as productivity is depressed by the ongoing economic contraction. Whether the most troubled country, Greece, which has already experienced three years of recession with a drop in real GDP by 13%, will be able to stabilise its economy within the EMU, remains to be seen.
It would be a grave mistake to think that the euro crisis is over: key issues still need to be resolved. Most importantly, countries presently undergoing external and internal adjustment programmes need to return to growth. If they are unable to do so, and if they are small enough not to cause a break-up of the euro, they will possibly have to leave the EMU. Large countries unable to adjust could not leave the EMU without destroying it, and would force the ECB to run an inflationary monetary policy, which would drag the euro exchange rate down. This would probably trigger a discussion of euro exit in other countries with a preference for a hard currency. Finally, the new fiscal policy framework and crisis management mechanism will probably fail their first serious test and will need to be developed further. As a result, unless the economic crisis suddenly lifts, the uncertainty about the long-term survival of the euro will probably be with us for the foreseeable future. The euro will most likely not disappear, but its country coverage could change and its nature could mutate from a hard to a soft currency.
The opinions in this article are those of the author and do not necessarily reflect the views of the OECD or the member countries
©OECD Observer No 290-291, Q1-Q2 2012