Magazine Blogs Bassanese

The first few weeks and months of a new year are usually a time for cheer, but watchers of the global economy could not help but notice repeated warnings over Europe. Both the International Monetary Fund and the World Bank issued dire warnings that the world’s economy was at risk of a re-run of the global financial crisis if Europe did not manage to get its fiscal house in order.

Greece has just finalised yet another bail-out deal to avoid a messy debt default.

Refresher course

Let’s recall the problem. Due to bad luck and poor management, countries such as Portugal, Ireland, Greece, Italy and Spain – or the so-called “PIGS” peripheral economies of the euro zone, found themselves with high levels of public debt and budget deficits.

This was, in large part, a consequence of being in the euro zone, as the reduced risk of currency depreciation due to adoption of the single monetary unit encouraged investors to lend to these countries at lower rates of interest – which led to a big run up in public and private debt.

Property bubbles

In Spain and Ireland in particular, the decline in interest rates and easy credit sparked a property bubble – not unlike that seen in the United States. In Italy, Portugal and Greece, excessive government borrowing has long been a problem, though made worse by the availability of cheap financing in the years leading up to the global financial crisis.

The economic downturn due to the GFC only made matters worse, blowing out budget deficits even further, due to the weakness in tax revenues and increase in welfare payments. As if that were not enough, countries such as Ireland spent billions bailing out their banking sector.

The government debt burden of these troubled countries had become so high that investors baulked at buying new bonds to finance future public deficits at anything other than very high interest rates – which only increased the risk that nations would default on their loans.

Of course, speculative hedge funds have also been involved – knowing that a money-making crisis could be created by selling short European debt and jacking up the interest rates that troubled countries faced.

Game of brinkmanship

One after another, these countries have been forced to seek cheaper funding from a specially designed European bailout fund and the International Monetary Fund – though only in exchange for promising severe budget cutbacks to reign in their government deficits.

Over the past year or so, markets have fretted, as a game of brinkmanship took place in Europe. While healthier countries such as Germany have been demanding deep budget cutbacks in exchange for emergency funding, they have not wanted to push too hard lest troubled places like Greece simply default on their debts and give up on the euro zone.

Indeed, while Greece is only a small part of the region’s economy, the great concern has been that allowing even a single country to simply default on its sovereign debts unilaterally – and worse, drop the single currency – would spark fear that larger members, such as Italy and Spain might do likewise.

Time for technocrats

By late last year, useful changes had been put in place. Technocratic governments have been installed in Greece and Italy – to ram through budget cuts and economic reforms even in the face of stiff public opposition. The European Central Bank has started to lend massive amounts to the continent’s banking sector – temporarily reducing its reliance on fickle private finance and allowing it to keep buying the sovereign bonds of Europe’s troubled periphery. In a way, the ECB has seemingly engaged in backdoor funding of troubled governments through the banking sector.

Meanwhile, euro zone leaders have agreed to a larger bailout fund and tougher future policing of member countries’ budget policies. Never again, so the politicians promise, will countries be allowed to run up unsustainably large deficits.

A near miss ... so far

While many doubt the long-term effectiveness of these moves, so far at least, the worst-case scenario for Europe – a disorderly debt default and/or a country deciding to leave the zone – has been avoided. Indeed, in financial markets, the yields investors are demanding in exchange for owning troubled European sovereign bonds have eased in recent months, and equity prices have rebounded.

Of course, a lot can still go wrong. Recent data suggests European economic growth is likely to be very weak this year – and the region may well slip into outright recession. While Germany’s economy is doing well – helped by the effect of a shaky euro on its powerhouse export sector – growth in troubled countries such as Greece and Italy will be especially unsteady, if not bordering on depression.

In turn, the softer growth will make it harder to rein in large deficits. Indeed, there’s a very real risk Greece’s latest bail-out deal will create a negative cycle of deeper budget cuts that would only make growth weaker and deficits larger.

Higher than expected budget shortfalls could easily recreate crisis conditions, as the game of brinkmanship between those needing and providing finance would begin all over again.

Widening gap

Not helping is the growing competitiveness gap between the north and south. Germany has undertaken tough reforms to labour markets in recent years, and productivity growth has responded favourably. Technocrats are now trying to administer the same tough medicine in Italy and Greece, though progress will not be easy.

The single European currency was a bold and, with hindsight, perhaps naive experiment that began with a potentially fatal flaw: countries were still allowed to rack up public debt as they saw fit. If the euro is to survive, member nations will ultimately need to move to full fiscal union and the issuance of common euro zone bonds. That will require countries to give up a lot more economic sovereignty, but it seems that’s the price they’ll have to pay if the single currency is to have a chance of surviving.

If Europe can’t agree on full fiscal union, then the euro is not worth saving.