Decoded: The future of the euro

George Magnus

As a tentative calm returns to European markets, buoyed by last summer’s commitment by the European Central Bank’s president to preserve the euro at all costs, leading economic adviser at UBS Investment Bank, George Magnus, surveys the fragile financial landscape and asks, what lies ahead for the euro system?

During another acute phase of market turbulence in the eurozone in late June 2012, Mario Draghi, president of the European Central Bank (ECB), promised that he would do whatever it took to save the euro. Since then, and especially after the ECB’s announcement of a new sovereign bond purchase initiative – called Outright Monetary Transactions – in early September, the sense of crisis in European financial markets has evaporated.

By early December, yields on long-term Italian government bonds had fallen to the lowest level in two years. Spanish yields had fallen back to levels in March, and even in Greece, where yields had reached almost 40 percent in March, they had dropped to about 15 percent. Comforting as these market developments have been, the euro crisis is a long way from being resolved – a task that lies in the hands of European leaders, not the ECB.

The ECB, however, has managed to buy some time. It has assured financial markets that it will lean heavily against the self-fulfilling market risk of a country leaving the eurozone, reflected in high rates, for example, in Spain and Italy. The so-called ‘tail-risk’ of a break up in the euro, therefore, has disappeared.

Becalmed markets, though, do not mean the crisis is over. Greece’s latest €44 billion lifeline with easier debt service conditions, will count for little if domestic political and social developments culminate in an impasse with creditors, and debt repudiation. And despite the ECB bond plan, Spain has not yet asked for help. It almost certainly will within the coming months, as its solvency credentials are deteriorating. Italy, whose credibility had been restored by technocrat Prime Minister Mario Monti, might face new risks if the national elections, now brought forward to February after Monti’s decision to stand down in December, result in weaker government and governance. Portugal is likely to get a second financial programme as its debt sustainability begins to resemble that of Greece. And France, whose own debt and deficit dynamics are being subjected to closer scrutiny, may be ‘one to watch’ in 2013.

All countries share one large, common problem, namely the extinction of economic growth. Eurozone GDP is expected to contract for a second consecutive year in 2013. Two major problems underlie this malaise. First, the widespread implementation of ‘austerity’ policies is having effects on the economy that are significantly larger than expected. Second, while debtor nations have no choice but to cut and implement painful structural reforms, creditor nations are not playing their full part. They are resistant to the call for larger financial transfers from richer, northern Europe to the south, and they are unwilling to consider longer adjustment programmes for debtors.

Without a solution to the growth crunch, other policy initiatives to improve debt sustainability and the health of the banking system seem almost doomed to flounder. New rules to coordinate and supervise fiscal policies are widely trumpeted but of little relevance to this crisis. The most important fiscal initiative – the mutualisation of debt issuance throughout the eurozone – isn’t even on the agenda. More important are the proposals to create a banking union, beginning with the establishment of a, so-called, Single Supervisory Mechanism in the ECB with effect from 2013.

There is no question that the centralisation of supervision is an idea whose time has come, if Europe is to push the banking union agenda forward, and deepen the monetary union. And yet it still raises protectionist hackles in many eurozone countries. Inside the eurozone, Germany remains anxious about the ECB’s monetary independence and the scope of its supervisory role; outside the zone, so are Sweden, Finland and Poland.

If properly structured, a banking union would sever the current damaging linkages between weak sovereign and weak bank balance sheets. But this goes much further than supervision in at least two important respects. First, there has to be a pan-European deposit insurance scheme to put all banks and their depositors on a similar footing. Second, there has to be a strong, central resolution authority, which could shut down weak banks, force mergers and changes in ownership, and dispose of assets. Both of these measures would entail transfers of resources from the rich north to the poorer south.

With German elections due by the final quarter of 2013, no new major initiatives to resolve the euro crisis seem likely beforehand. The ECB’s bond purchase plan, once activated by Spain, might keep financial markets stable for a while. But the euro system will remain hostage to two important and unpredictable phenomena: the random decisions of governments, sometimes in the face of domestic unrest, and the absence of a universally acceptable template to restore economic growth, apportion responsibilities to both debtors and creditors, and transfer banking and fiscal sovereignty and resources to robust central institutions.

How will this all end? No one has ever successfully grafted a political union on to a monetary union, but no one should overlook the strong political commitment across the eurozone to preserve the single currency, or the popular will to make it work. A reasonable guess is that ‘muddling through’ will continue throughout 2013, that stronger integration initiatives will emerge to shape the euro in 2014-15, and that Germany and other northern European creditor countries will have to transfer more sovereignty, even if this entails the complex issue of changes to the European Treaties. But this is a political judgement, not a prediction. Politics are just as likely to cause best-laid plans to go awry.

About the author:

George Magnus is an economist and an adviser to UBS and other investment banks


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