By Ralph Atkins
Europe’s 11-year-old monetary union, stretching across 16 countries, is being tested to its limits. Governments, especially those of Greece, Portugal and Spain, face pressure from markets to cut deficits and reform their economies. Politicians are thinking about how to rewrite the rules for eurozone membership to prevent further crises.
The European Central Bank has been forced to intervene in government bond markets – a step it never dreamt it would have to take. The euro has fallen sharply. But will the tensions prove temporary? Might they bring improvements? Or will they destroy the eurozone? Here we consider four possible scenarios.
1 Order restored
The crisis forces governments to put public finances in order and improve the dynamism and efficiency of their economies. The eurozone becomes an engine of growth in the global economy.
Greece could, in perhaps a few years, become a model European economy. With its perfect weather, culture, history and dramatic scenery, the country could thrive as an upmarket, healthy-lifestyle destination for holidaymakers, the retired and entrepreneurs attracted by its transformed business environment.
That, at least, is the dream of eurozone policymakers. For now, Greece is on life-support. But International Monetary Fund and European Union programmes might put its public finances back on a sustainable footing. The years of austerity that lie ahead could create the conditions that unleash a self-starting, enterprising business spirit among Greeks and make up for years of lost competitiveness.
Elsewhere in the eurozone, Greece’s traumas could encourage pre-emptive action that triggers growth in countries such as Portugal and Spain. Germany could help the process by boosting domestic demand rather than focusing on just exports. A stronger, more dynamic eurozone would emerge.
The idea is not completely ridiculous. Athens is under enormous pressure to rebuild the country’s economy from scratch because the alternative would be catastrophic: likely bankruptcy, isolation from financial markets and widespread social tension (see scenario four).
Similar about-turns have occurred elsewhere. Sweden reinvented itself after a near-death banking and economic crisis in the 1990s, and offers lessons for others even though it is outside the eurozone. “My fear is that we’re going to run into a negative fiscal shock in the eurozone,” says Pontus Braunerhjelm, of the Swedish Entrepreneurship Forum. “Everyone will have to be like the Germans, and that could have a huge impact on demand. But our experience suggests this will force more structural reform in many countries. If it doesn’t, we risk falling into a vicious downward spiral.”
Eurozone politicians could, meanwhile, agree on procedures for preventing future crises. For too long, Greece hid the true state of its public finances. But statistical surveillance is now being strengthened. In future, action could be taken earlier against economic “imbalances” – for instance, when countries lose competitiveness through excessively high wages. Institutions could be created to handle crises in an orderly manner when they do emerge – so, for example, if a debt rescheduling became necessary in, say, Greece, disruption elsewhere would be modest. The ECB would be able to retreat and focus solely on combating inflation.
Likelihood: Not impossible – but do not hold your breath.
Implications for the euro: The single currency would become a serious challenger to the dollar as a strong and stable reserve currency.
2 Muddling through The eurozone stabilises but fails to address fundamental problems in its construction exposed by the crisis.
Government and ECB action – including the €750bn ($925bn, £640bn) emergency eurozone rescue programme agreed last month – could calm the current financial market storms. Greece’s credibility with investors could start to be restored as it implements its austerity programme. Spending cuts and tax rises implemented by Spain and Portugal could strike just the right balance between bringing down the public sector deficits and not sending the economy into a downward tailspin.
But the changes might not be enough to pep up eurozone growth prospects much, and Greece might have to wait before it becomes Europe’s answer to Florida. More crucially, the fundamental flaws in the monetary union – which have been left exposed by the crisis – could remain uncorrected, spelling trouble ahead.
For much of its first decade, the eurozone appeared to be living the dream, says Daniel Gros, director of the Brussels-based Centre for European Policy Studies. Germany entered at too high an exchange rate and became the “sick man of Europe” but staged a dramatic comeback by restoring international competitiveness through labour market flexibility.
The problem, Mr Gros says, was that the eurozone “overshot”. Not only did Germany make up for the initial over-valuation, but ruthless cost controls also gave it a big competitive advantage – mirrored by an equally dramatic loss of competitiveness in countries such as Greece. Now it is the latter’s turn to cut costs but emulating Germany is not easy. “This is how the European economy works – many countries have national labour markets and social institutions where there is a lot of inertia,” says Mr Gros. “I expect continued pendulum swings.”
The debate among eurozone politicians today goes beyond ways to manage crises better, and includes ways to ensure such “imbalances” are identified and tackled in good time. It is not clear agreement will be reached, however. For some, the debate is already heading in the wrong direction. The ECB’s intervention in government bond markets last month is seen in Germany as simply encouraging fiscal profligacy – and raising inflation risks. Berlin opposes any steps undermining German manufacturing competitiveness.
Even if reforms are devised that make the eurozone function better, the politicians might renege on the deal. After all, Germany and France forced a loosening of the eurozone’s fiscal rules in 2005 after themselves breaching the budget limits. Mr Braunerhjelm in Stockholm says: “All of Europe’s history, traditions and the way the EU proceeds points to this being a slow, incremental process – not some shock change.”
Likelihood: Distinctly possible.
Implications for the euro: Weakened growth prospects and exacerbated long-term political worries will pile on the downward pressure
3 Walking wounded The eurozone is permanently weakened, its long-term future thrown into doubt.
The demands facing southern European economies could prove too much. Greece might remain hospitalised longer then expected and face a debt rescheduling. Portugal or even Spain might follow. Social unrest could rise to intolerable levels if austerity measures imposed by the International Monetary Fund and EU are not seen to be yielding results. Speculation about the break-up of the eurozone would mount.
The impact on German and French banks, plus plunging economic confidence, would threaten a deep recession across the eurozone, while the falling euro would stoke inflation.
That could be the result if eurozone leaders fail to find a way of turning around the fortunes of countries such as Greece. Jean Pisani-Ferry of Bruegel, the Brussels-based think-tank, points out that the combination of poor public finances and uncompetitive industries has proved lethal to nations on Europe’s southern periphery. To restore competitiveness, countries need to “deflate” by cutting wages and prices, “but if prices go down and your debt remains high and the economy shrinks, then the burden of your debt rises”. Ideally, he argues, Germany would allow inflation rate to rise above the eurozone’s 2 per cent target to help other countries adjust – but it is hard to see the country’s inflation-wary population agreeing.
The risk, Mr Pisani-Ferry says, is that parts of the eurozone become “a sort of Mezzogiorno [southern Italy] or eastern Germany, in which you get no adjustment and high levels of unemployment”.
Unlike Sweden in the 1990s, struggling eurozone countries would not have the option of devaluing against their main trading partners, although the euro’s weakness would help boost exports beyond the region.
Such a scenario would be highly dangerous for the ECB. Already it has come under attack in Germany for its – so far modest – interventions in government bond markets. The danger is that it would be forced to expand the programme into full-blown “quantitative easing”, in which the inflationary impact is not offset by withdrawing liquidity from other parts of the financial system.
Similar steps were taken by the US Federal Reserve and Bank of England at the height of the global economic crisis that followed the collapse of Lehman Brothers in September 2008. But for Germans, quantitative easing by the ECB would violate two principles they saw as fundamental to the eurozone when it was launched in 1999: strict independence of the central bank from politics; and government responsibility for keeping their country’s public finances in order. Angst about higher inflation would surge further – adding to popular disgruntlement with the monetary union.
Implications for the euro: Long-term weakness
4 Break-up The end of the euro project. Tensions become too great to manage; one or more countries decide that they would be better off out – or other eurozone countries decide to eject them.
Greece’s economic collapse, recession and soaring unemployment elsewhere in the 16-country region, growing popular resentment towards the euro – if events took several turns for the worst, the nightmare scenario could come closer to reality. Rather than offering an easy way out of the current difficulties as some in financial markets seem to think, a debt default or rescheduling by a eurozone country could unleash unpredictable, destabilising forces across the region.
Nobody ever planned for a eurozone break-up. Entry into monetary union was seen as an irreversible process; there is no exit clause. But that does not mean it is impossible.
An orderly withdrawal might make sense for eurozone countries that “are fundamentally different from the others”, says Ansgar Belke, economics professor at the University of Duisburg-Essen in Germany. “Portugal has little to export. They compete with emerging markets so to turn the economy around they would have to cut wages so far that there would be a very deep recession. The same, of course, is the case for Greece.”
One possibility, he suggests, is that an institutionalised system for organising an “orderly default” by a member state could also include the possibility of exiting the monetary union. Angela Merkel, Germany’s chancellor, has suggested recalcitrant eurozone members might, in future, be asked to leave.
The problem is that an orderly withdrawal would be hard, if not impossible, to achieve. Most economists also agree the costs of leaving would be huge – whether for a country exiting in disgrace (Greece, say) or by choice (Germany, for instance). Greeks would still face the prospect of paying massive overseas debts in euros, but with a much weaker new drachma; German companies could find themselves priced out of business by a soaring new D-mark. The costs of doing cross-border business would soar for exporters and foreign exchange volatility would become a big obstacle to economic growth.
If it became clear that an exit from the eurozone was possible after all, the pressures might be such that there would be a rush for the door. As such, the monetary union – a dream of European policymakers since the second world war – could fall apart. The future of Europe’s economic integration would be thrown into reverse. Speaking in Aachen, Germany, last month, Ms Merkel declared that, if the euro fails, “then not only the currency fails ... Europe will fail, and with it the idea of European unity.”
Likelihood: Remote – but not as remote as previously thought.
Implications for the euro: The currency would weaken dramatically well before any break-up loomed.