Is the worst over for the euro zone?

September 25, 2012

Spain’s stock markets have surged in the past month, and the interest rate its government pays to borrow money has dropped. The latest data indicate euro-
region banks and corporations are able to raise money more easily from private investors.

Snapshots to be sure, but there is a building sense that recent steps by the European Central Bank and European officials have put a floor under the euro zone’s festering crisis and begun restoring confidence that the currency union won’t crack apart.

Plenty remains to be done. Spain will release critical details of its upcoming budget and a pending bank rescue program this week, politically sensitive announcements that triggered large protests in Madrid on Tuesday in opposition to continued government austerity programs.

Greek, European and International Monetary Fund officials remain at odds over how to fix Greece’s problems. Important proposals such as the establishment of a European banking union have been accepted in theory but not completed. And the region’s economy is firmly in recession.

Yet the likelihood of an acute new crisis arising from Europe — a preoccupation of policymakers in the United States and elsewhere for going on three years — seems to be fading along with the risk of a broader breakup of the 17-nation currency union.

Recent actions, most notably promises by the European Central Bank to begin buying government bonds in unlimited amounts, were “clearly a turning point,” IMF Managing Director Christine Lagarde said this week. “I can’t say enough about how good the [ECB] decision was in the view of stabilizing markets.”

After pressuring Europe since early 2010 to take many of the steps eventually enacted, U.S. Treasury Secretary Timothy F. Geithner said at a forum in New York on Tuesday that the situation now “looks a little better than it did,” with measures in place to finance troubled governments as they work to revive their economies.

Analysts and investors have begun to temper their concerns about short-term calamity. The money pushing up Spanish and other European stock indexes and bolstering the value of beleaguered bank shares is another positive sign.

Even usually hawkish analysts such as those at London-based Capital Economics, among the staunchest euro pessimists, acknowledged that recent events “have arguably brought the euro zone back from the brink.”

Along with the ECB’s bond-buying announcement, a subsequent German court ruling paved the way for a new bailout fund to begin operations. It is now scheduled for early October. And tentative steps have been taken to create a banking union to better regulate European financial institutions and share the cost of any major failure.

The crisis in the euro zone emanated from Greece’s slide into insolvency but broadened into a series of interrelated problems: Collapsing property values in some nations broke the financial health of governments that were forced to bail out local banks. Healthy banks suddenly faced losses because they had invested in shaky government bonds. Slow economic growth compounded the problem.

When the survival of the euro came into question, investors fled to other currencies or retreated behind national borders by selling off their holdings in troubled countries such as Greece.

Instead of the currency union encouraging financial and economic integration, it was suddenly the vehicle for potential collapse. A nation outside such a union, with its own central bank and currency, would have more tools for responding to such a crisis, from devaluation to outright controls on the flow of capital.

But Europe’s breakup risk has not completely disappeared.

Greece remains in economic free fall as the government there struggles to come up with roughly $15 billion in budget cuts for the next two years. An international bailout program, partly funded by the IMF and partly by other European nations, is running badly behind schedule. Unless Greek officials come up with a satisfactory combination of cuts, new revenue and other steps, further rounds of international lending may be suspended, forcing the country to drop the euro.

But the announcement of the new ECB program has furthered the sense that Greece is an isolated case, with the central bank all but guaranteeing that countries that follow agreed-upon economic policies will be backed by the bank’s unlimited balance sheet.

The ECB bond-buying program is supposed to work in concert with the separate bailout fund — countries will not benefit from either unless they appeal for help and agree to policy conditions — and some say that until money starts to flow, there is reason for skepticism.

Spanish officials, for example, may hope that their upcoming budget is so convincing on its own that they will not need outside help — a situation that may set the stage for another round of crisis if their plan fails.

“The ECB did not buy any bonds yesterday under its newly invented program,” Carl Weinberg, chief economist at the High Frequency Economics consulting firm, wrote in an analysis noting the limits of what the ECB is prepared to do. “It will not buy any bonds today or tomorrow, or this week or next week, or this month or next month.”

And even if the euro’s short-term risks have eased, its longer-term battle to restore economic growth remains — something ECB President Mario Draghi said needs to be the focus of officials now that the central bank has offered its help.

“We have played a role in improving overall confidence by removing unfounded fears about the euro area,” Draghi said Tuesday in Frankfurt, Germany, but he called the current pause in the crisis merely “a bridge” that European officials must supplement with better economic policies.

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