The Eurozone crisis has been in retreat since the introduction of the European Central Bank’s (ECB) three-year long-term refinancing operations (LTROs) in late December 2011. At the European Council Meeting in early March, journalists who cover the crisis fretted that boredom loomed. The current lull does not indicate that the Eurozone is in the clear, but rather it is simply in the eye of the storm, and more drama inevitably awaits.
Extend and pretend
So far, there are three key mechanisms the troika — the European Commission, International Monetary Fund (IMF) and ECB — has employed to buy time for the Eurozone’s weaker countries to regain competitiveness and return to growth. Each of these could fail over the next few years, prompting a renewed intensification of the crisis.
The first of the Eurozone’s time-buying mechanisms is the bailout programs that have been provided to Greece, Portugal and Ireland. Greece is the most recent country to receive a European Union (EU)/IMF bailout, its second since the beginning of the crisis. The second bailout program has been predicated on growth assumptions that have already proven to be overly optimistic, with Greek gross domestic product (GDP) in 2011 actually falling much more than the troika estimated. A funding gap has already opened up in the second bailout program before the ink has even dried on it. This does not bode well for Greece being able to return to the markets when official funding runs out.
It also seems unlikely that Portugal will manage to borrow in the markets when its bailout runs out next year. Parliaments in the core countries such as Germany and the Netherlands will probably be asked to approve additional support packages for the bailout countries. Patience in the core for bailouts is waning. This is exacerbated by the fact that Germany and the Netherlands have recently had trouble meeting their own fiscal targets.
The second mechanism has been the ECB’s three-year LTROs, which Eurozone banks have used in part to sop up peripheral sovereign debt. In the short term this has reduced borrowing costs for the Italian and Spanish governments (see Figure 1). But the LTROs have not magically reversed the fundamentals. Both countries will record appalling GDP figures over the next 12-24 months as the short-term effects of austerity measures and structural reforms bite. These growth numbers will scare investors, and the risks associated with a large peripheral country defaulting will increase again. Furthermore, it is potentially dangerous for banks to use ECB liquidity to buy more sovereign debt, strengthening the negative feedback loop between Eurozone banks and sovereigns. A default by one bank or country could spark cascading defaults across the region.
Figure 1: Ten-year government bond yields
The third way the troika has tried to buy time is with a so-called firewall consisting of EU bailout funds and bilateral loans to the IMF. This is designed to take Italy and Spain out of the markets for a few years should they face unsustainably high borrowing costs. The hope is that these countries would be able to implement structural reforms and see those reforms boost growth by the time a return to the markets is required.
But for the firewall to work both its EU and IMF elements must be large enough. This is far from guaranteed, and failure on this point could trigger a massive escalation of the crisis. On the EU side of the firewall, there are currently two funds in place, the European Financial Stability Facility (EFSF), which has around 250 billion euros in available funding, and the 500 billion euro European Stability Mechanism (ESM). The former is due to replace the ESM in June 2012, but the only way to amass enough funds to cover Italy and Spain’s financing needs for a few years is to run the EFSF and ESM concurrently. However, German Chancellor Angela Merkel remains — for now, at least — vehemently opposed to this idea. Similarly on the IMF side, many countries have indicated their reluctance to contribute to a firewall until the Eurozone devotes more of its own collective resources to solving its crisis.
Figure 2: Composition of the Firewall vs. Financing Costs for the PIIGS (€, billions)
Source: EFSF, ESM, RGE estimates
* We assume that Italy and Spain will not be forced to request official financing before 2013
Making the most of borrowed time
Even if all of these efforts to buy time go off without a hitch, there is a significant risk that social and political factors will lead the weaker Eurozone countries to squander the time that has been bought for them, rather than implement the difficult reforms that are needed.
We have already seen social unrest in all of the peripheral countries save Ireland. I expect that we will see a significant increase in social unrest in the weaker Eurozone countries as growth and living standards continue to plummet and unemployment rises further. With trade unions and the public in many peripheral countries so vehemently opposed to the unpopular structural reforms that have been announced, implementation is likely to be delayed.
A second threat to the implementation of structural reforms comes from a number of key elections in the Eurozone over the next two years. In Greece, an election in April or May 2012 may well lead to a cycle of social unrest and fresh elections. This could eventually see an anti-austerity, anti- Eurozone Greek government brought to power, thereby creating unprecedented risks of a unilateral Greek default and Eurozone exit.
Meanwhile in Italy, Prime Minister Mario Monti has taken strides towards liberalizing the economy and restoring the public’s faith in government. But Monti will exit the scene when there is an election in April 2013 and the risk is that political instability and drift will take his place as a new coalition government succumbs to gridlock.
This crisis has legs
Even if the Eurozone survives the current crisis fully intact, there are reasons to worry about further crisis lying ahead. The cycle of boom and bust is such that at some point the euro area will hit another economic and/or financial shock. But the troika’s current crisis-resolution approach of extend and pretend will have done nothing to position the Eurozone to survive such shocks any better in the future. Ultimately, unless the fundamental structure of the Eurozone is reformed so that political union leads to fiscal transfers or joint and several liabilities, this crisis will inevitably rage on.