Is Europe out of the woods? Certainly a number of key credit spreads, particularly in Spain and Italy, have narrowed substantially. But the interpretation of improved market conditions is far from clear. Restrictions limit pessimistic investors’ ability to short European debt. Regulations enable local banks to treat government debt as risk-free, and they can fund it at the European Central Bank (ECB) on better-than-market terms. The suspicion exists that, if necessary, the ECB would come in strongly and bail out bondholders. Remissions sometimes are followed by cures and sometimes by relapses.
A worrisome recent indicator in much of Europe is the substantial tendency of stock and bond prices to move together. When sentiment improves in healthy countries, stock prices rise and bond prices fall as risk premiums decline and interest rates rise. In unhealthy economies, however, as in much of Europe today, bonds are seen as risk assets, so they are moving, like stocks, in response to changes in sentiment.
Perhaps it should not be surprising that Europe still looks to be in serious trouble. Growth has been dismal; the euro-zone gross domestic product has been below its 2007 level for six years, and little growth is forecast this year. For every Ireland, where there is a sense that a corner is being turned, there is a France, where questions increasingly arise about the political and economic sustainability of policy.
The controversy surrounding the decision by the European authorities to bail in Cypriot bank depositors suggests the degree of fragility in Europe. The idea that converting a small portion of deposits into equity claims in an economy with a population of barely more than 1 million could be a source of systemic risk suggests the hair-trigger character of the current situation.
Everything is compounded by political uncertainty. Italy’s last election was inconclusive even by Italian standards. Scandals and staggeringly high unemployment are taking their toll in Spain. France is much calmer about its situation than are many outside observers. And Germany’s primary concern is avoiding turmoil ahead of its fall elections. Given a choice, all would almost certainly prefer some kind of macroeconomic unorthodoxy to the breakdown of their monetary union. But there is a serious risk that as nations pursue their parochial concerns, the political and economic situation will deteriorate beyond repair.
Continued structural reform in the most troubled economies is essential, and the work of building a more satisfactory institutional foundation for the euro must go on. Critical to success will be (the belated) recognition of the paradox that in economic policy, as in so much of life, what is good for one is not good for all.
German policymakers constantly note that fiscal consolidation and structural reform were key to Germany’s rise from “sick man of Europe” to today’s position of strength. But Germany’s export growth and huge trade surplus were enabled by borrowing on the European periphery. If Europe’s debtor countries are to follow Germany’s historic adjustment path without economic implosion, there must be a strategy that assures increased external demand for what they produce. Simply put, there cannot be exports without imports. This could come from a German economy prepared to reduce its formidable trade surplus, from easier European monetary policies that spur growth and competitiveness, or from increased deployment of central funds such as those of the European Investment Bank or perhaps other sources. The crucial point is that no strategy for debt repayment can succeed without providing for an increase in the demand for the exports of debtor countries.
Invocation of necessity is not a strategy. As any student of Germany’s experience of the 1920s knows, it is far from a viable strategy to require a nation to service large debts by being austere when there is no growth in demand for its exports.
European policymakers, the International Monetary Fund and others with a stake in Europe’s outcome need to recognize that the history of financial crisis is a history of windows of opportunity missed. New business is always more exciting than unfinished business. And where matters are controversial, forced moves are easier for policymakers because they can be portrayed as moves of necessity rather than choice. So outsiders avoid confrontation and insiders embrace drift. The consequences could be grave.