Euro-zone Update!

If things get rough across the globe expect eyes to return to problems in Europe, where they continue to talk. I have not written much about the Euro-zone as of late because nothing is really happening. The Euro-zone is engaged in a talkathon, with fear of an immediate collapse off the table the members of the Euro-zone much like their political counterparts in America just talk about solutions without any action. For us in America news from across the pond dribbles out in small doses with almost daily media boost of promises that things are getting better. Little is said about how at a recent EU summit in Brussels Merkel ran into an almost unified wall of opposition  from both creditor and debtor countries alike as she pushed for something solid such as using  “contracts” to promote economic reforms and address serious issues.

Without the fear of an acute crisis that might endanger the euro Germany has lost leverage to move reform along. In the past, countries desperate for Germany’s financial backing quickly agreed to treaty changes to  satisfy Angela Merkel and fill her need to placate the judges of the German constitutional court.  Germany pushed the idea that countries should sign binding contracts with European institutions concerning promised reforms in exchange for additional economic help. Northern hawks  like the Netherlands and Finland continue to be adamantly opposed to additional transfers, fearing they might become permanent. Southern doves rejected the idea of yet more control and over-site of reforms imposed from Brussels, especially if only small amounts of money and aid come with them. The result is a “negative coalition” of the rival camps who opposed the German idea for completely different reasons.

Problems in the Euro-zone ultimately stem from the loss of competitiveness in the countries of the periphery where wages have outrun productivity. Germany's wants structural reforms to labor and product markets to get more growth. Voluntary initiatives, starting with the Lisbon Agenda seeking to make Europe more competitive and dynamic have achieved little. The Euro Plus Pact of early 2010, whereby countries would make voluntary pledges that would be reviewed yearly by peers has produced little fruit. The commission’s “country-specific recommendations” are generally ignored.  Today many leaders feared the unpopularity of such moves will feed the rise of anti-establishment, anti-EU and anti-immigrant parties before May’s European election. So the idea of contracts have been repeatedly pushed off since autumn of 2012 into late 2014. Merkel will now begin a waiting game, sooner or later somebody will want Germany to commit more money to stabilize the euro zone then she will push her contract agenda through.

When it comes to the issue of austerity, governments have found it easier to cut deficits by raising taxes than reducing spending or address the rigidities in the labor and product markets that retard growth. In the Financial Times Mario Monti, the former Italian prime minister, offered two explanations for reform-aversion. First, structural reforms run into organized opposition from groups that enjoy benefits. Raising taxes causes only generalized grumbling. Second, European rules focus primarily on controlling debt and deficits and not the underlying workings of the economy. Countries that have been forced to seek bailouts have already enacted major reforms, In truth the contracts are really aimed at vulnerable countries like Italy and France that have not come under official programs. All that Enrico Letta, the Italian prime minister, would say was that “the time was not right”. France has gone so far as to say the commission should not “dictate” the shape of reforms.

 
As for the long awaited Banking Union, the absence of a permanent burden sharing agreement to end the doom-loop between weak sovereigns and weak banks remains elusive. A recent article in the Financial Times pointed out that  progress towards the necessary institutional framework is not the same thing as completion. While a banking union is no panacea for the euro zone’s ills it would ensure that taxpayers of individual countries are not called upon to save the banks, but for this to work there must be some assurance that everyone will stand behind it. The latest draft proposes to maintain the link between banks and sovereigns in the transition period but if the resolution fund runs out of money, national treasuries would have to step in. Currently there is agreement on a bail-in scheme for banks that will involve creditors if a bank fails, but  there is no pan-European deposit insurance or resolution scheme with  a single euro zone-wide deposit-guarantee system using a common backstop similar to America’s FDIC. 

While what has been agreed to would transfer to European authorities the supervision of euro-zone banks and the power to handle their liquidation if necessary it fails to address key issues. Even the IMF has warned that a half-baked, piecemeal banking union could be worse than none. Currently the most troubled countries remain vulnerable to bank runs. Worries exist this year’s European elections might generate surprises on the extremes and the independence vote in Scotland if successful could cause problems across the EU. Given the work still to be done at the institutional level and the risk of surprises on the downside, some pricing looks hard to justify. With bonds in some core European markets such as Belgium, the Netherlands and France near pre-crisis spreads they possibly do not reflect financial and economic reality. Unfortunately without a crisis little gets done, it appears the Euro-zone and the world has been lulled into complacency by all this talk. It seems we have already forgotten the lessons of the great financial crisis.


Footnote; Please feel free to explore the blog archives and as always you comments are encouraged.