Keith Wade, Chief Economist at Schroders, looks beyond the near term cyclical challenges and considers what the Eurozone needs to do to ensure its long term viability…
Divergence rather than convergence
• One of the fault lines to address was predicted before the single currency even started and is the divergence in economic activity which results from a one-size-fits-all monetary policy.
• Such a pattern soon became apparent in the Eurozone with low inflation Germany and the core countries enjoying increasing trade gains as the periphery sank into deficit. There was some convergence of income per head across the region, but this was accompanied by growing imbalances.
• Prior to the financial crisis such imbalances were easily financed as cross-border lending accelerated. After the crisis capital flows dried up and went into reverse as banks cut their exposures.
• Whilst we may eventually get to European political union and a common exchequer for the Eurozone, there is no mandate for it at present. So we have to find other means of redistributing the gains and losses.
• One means of moving closer to a fiscal union would be to issue Eurobonds, effectively mutualising the guarantee on the public debt of Eurozone counties.
• The aim would be creation of a euro-area safe asset, where sovereigns would be jointly liable for debt.
Banks and Sovereigns
• The second fault line was not anticipated prior to the creation of the euro: the fact that banks and their sovereigns are inextricably linked such that their debts need to be considered together rather than separately.
• Banks and Sovereigns each have the potential to bring the other down and the Eurozone has had cases of both, with banks in Ireland and Spain bringing crisis upon the sovereign and vice versa in Greece.
• It has proved very difficult to break this link as once a banking crisis has infected the sovereign; the fall in the creditworthiness of government debt further undermines banks’ balance sheets, creating a downward spiral.
• One means of stopping the negative feedback loops would be to build a banking union, which could create a level playing field across the Eurozone and help break the vicious cycle linking banks and sovereigns.
• This seems to be where we are heading and progress is being made in terms of the appointment of the European Central Bank (ECB) as the region’s supervisor and on which banks will be covered. However, the more important issues involve the organisation of a resolution mechanism when banks fail and the nature of deposit insurance.
As the euro crisis has evolved, it has become increasingly apparent that Europe makes progress through a series of crisis. Only when faced with the prospect of the system breaking down do we discover what is a non-negotiable line in the sand from a bargaining position. As financial markets have found, brinkmanship is an integral part of politics and hence the resolution process.
However one of the side effects of the ECB’s policy of flooding the markets with liquidity (actual or threatened) and reducing market volatility has been to reduce the risk of a crisis. Peripheral bond spreads have continued to tighten as investors hunt yield, believing that the ECB sands behind them. Clearly such action has created a much needed breathing space for the euro, but by removing the danger of crisis it has taken the pressure off governments to take action.
Germany and the other core countries (Benelux, Finland and France) have benefitted from the trade gains created by the single currency and are now benefitting indirectly from the crisis through extraordinarily low levels of interest rates. According to Deutsche Bank, Dutch government bond yields are at their lowest for 500 years. The route to a sustainable euro will involve persuading the core to give up some of these gains on rates for higher growth and a stable euro over the medium term.