2011 was supposed to be the make-or-break year for the euro. First it was weeks, then just a matter of days to save the euro. Yet, 2012 has begun and we are still paying our taxes and bills are writing our contracts in euros. Not only here in Brussels, but also in Bologna, Barcelona, Braga and – perhaps most surprisingly – Berlin. Yet it is equally clear that the single currency is not out of the woods? Has the apocalypse merely been postponed a year?
This column looks at the current state of the euro area at the start of 2012 and its prospects for surviving beyond the end of the year. First, we need to review the key developments of last year.
2011: A look back in anger
The euro’s survival of 2011 should not does not mean that the year was anything other than a policymaking disaster. It’s true that European policy is institutionally and politically complex. The euro area had design faults that needed fixing, some of which made resolving the crisis even harder. Nonetheless, the complete collective failure of Europe’s policymakers to contain a crisis in the peripheral countries and prevent it from corroding the whole currency area is one of historic proportions. Let us sum up a sorry tale as quickly as possible.
What Europe’s policymakers had to do, in a nutshell, was simple. Prop up those (small) countries facing an immediate fiscal crisis and exclusion from the markets and avoid contagion. Nurture the nascent recovery, both for its own sake and to facilitate fiscal consolidation. And begin the process of rectifying the current account and competitiveness imbalances that had built up during the pre-crisis period.
(Yes, there were other important points on the agenda, like financial market reform, but these three elements were necessary and probably largely sufficient conditions. Recapitalising the banking sector could be considered a fourth, separate concern, but this issue largely arose as a result of the failure to address the other three prime concerns).
Task one required deploying relatively small amounts of money to ensure debt service for a reasonable period and displaying a willingness to deploy somewhat larger sums if necessary. It was key to keep interest rates on sovereign bonds low, hence, all bondholders had to be sure of being repaid in full (some form of common euro area bond would certainly have been welcome as well).
Task two required that, given the starting point at the end of 2010, above all else, no harm should be done: not launching premature austerity policies across the entire continent, not raising interest rates, not insisting on speedy increases in banks’ capital cushion (a boost to public investment, especially in the periphery, would certainly have been welcome as well).
Task three needed the symmetrical application of some combination of three feasible and well-understood strategies to balance current-accounts: ‘talking up’ nominal wages and prices in surplus countries, especially Germany, while ‘talking them down’ in the uncompetitive periphery; institutional reform to encourage faster/slower nominal wage growth in surplus/deficit countries, and differentiated demand management through fiscal policy – stimulus in surplus countries whilst shifting earlier to fiscal consolidation in deficit countries. (A higher aggregate inflation target to permit the competitive adjustment with minimum damage to real economic growth would certainly have been welcome as well.)
Europe failed catastrophically on all counts. Backstops provided were inadequate; the interest rates demanded were too high. Private bondholders were virtually told to expect future losses on their holdings of euro-area sovereign debt via the idiotic policy of private-sector participation (aka ‘voluntary’ debt write-downs). The whole continent embarked on a devil-take-the-hindmost race to implement fiscal austerity, based on the spurious idea that the problem was fiscal mismanagement, while the ECB hiked interest rates: the economic recovery – briefly strong in early 2011 – was successfully brought to a halt by the end of the year. The approach to competitive rebalancing was wholly one-sided, focusing on ‘internal devaluation’ brought about by massive demand deflation in the periphery, with no offsetting expansion in the core.
Let us leave the post mortem there. The gory details can be found in the columns and blogs written last year by SEJ authors such as George Irvin, David Lizoain, Stefan Collignon and myself. Where does this failure leave us now?
2012: Situation and prospects
The core tasks remain, essentially, the same as last year. So, in principle, do the solutions: guarantee sovereign debt servicing, stimulate aggregate demand and bring about faster and slower nominal wage and price growth, relative to the euro area average, in the core and periphery respectively. Therefore we can translate ‘to be or not to be’ for the euro area in 2012, into the question: How have the prospects for making progress in addressing this trinity of vital challenges changed in January 2012 compared with last year?
Resolving the sovereign debt crisis
Despite appearances, prospects for the euro area have worsened. In most cases the fiscal numbers are barely improving despite – in fact largely because of – aggressive austerity measures. These are set to worsen as the economy slows further.
Despite the fiscal pact agreed in December and due to be finalised this month, the ECB has refused to tackle the crisis directly with some form of explicit ex ante commitment. The most generous interpretation is that it is pursuing a sort of ‘trickle down’ strategy in which the banks, to which it gave a Christmas present of half a trillion euros, are fattened to the point that crumbs spill over to sovereign governments. Apart from being objectionable on normative grounds – amounting to a transfer from the taxpayer to bank shareholders – it is hard to see this strategy working. The banks are parking money back with the ECB and will only lend to governments (and businesses) at low interest rates if there are realistic prospects for economic growth. But as we will see, these are bleak.
It seems probable that, as last year, the only thing that would induce a change of course is a massive run on the banking system – which is less likely now due to the perceived ‘success’ of the three-year loans to the banks. The recent triumph of Italy and Spain in selling bonds at lower interest rates is, in that sense, a classic Pyrrhic victory.
If the ECB remains inactive, will any other white knights arrive? The European Stability Mechanism is fine in principle, but well known to be inadequate in practice: too small to cope with Italy and Spain, and even its solvent backers are threatened by downgrades. As part of the December deal Eurobonds seem to be off the table. And even if they could be introduced, it would be too little too late. The ECB is the only dragon-slayer around. But it is fighting the wrong battles.
On current policies the fiscal crisis will at best rumble on, and each bond sale represents a new opportunity for it to spiral out of control.
Boosting demand and growth
Prospects are without doubt very much worse than they were. The euro area will see a renewed slide into recession this year. Even Germany may well experience a recession. It is no longer enough merely to do no harm. (although even that would be progress). Austerity has been ramped up further going into 2012 and it effects will reverberate across the whole monetary union.
Against this the reversal of last year’s ECB rate hikes are welcome (and an embarrassment to the institution) but of limited importance. The three-year loans to the banks have merely reduced the risk of a major seize-up: they will not boost activity on their own because they will not substantively be lent on to the real economy under current conditions.
Last but by no means least, austerity is being locked in for the medium and longer term by the fiscal compact (even if important details remain to be decided). Policymakers seem convinced that further bleeding will achieve the recovery that past attempts have so obviously failed to generate.
In short, benign neglect is no longer enough. The euro area now needs a substantial effort by monetary and fiscal policy to boost aggregate demand. At present this looks extremely unlikely.
Resolving competitive imbalances
Some progress has already been made and the European Commission (appendix table 48), at least, is forecasting some gradual further improvement in current account imbalances. This may be overly optimistic though. Germany, in particular, can be expected to struggle to avoid declines in its export surplus in the context of economic stagnation. More fundamentally, the adjustment pressure has focused almost exclusively on the deficit countries, in the face of all the evidence that absolute wage and price deflation is extremely costly to achieve (and dangerous). There are no signs of changes in Germany that would promote faster wage and price increases (especially the reversal of policies that have weakened collective bargaining, the introduction of a minimum wage). And also little sign in the periphery of less damaging methods of improving competitiveness (social pacts, innovation) than brutal demand deflation and an assault on the public sector.
In short, yes, imbalances will decline, but not quickly and not in the right way. This is at best a mixed blessing.
We can summarise our assessment as follows. Not only do the problems remain, in most cases their resolution has become more, not less difficult. The key decision makers remain, for now, the same as last year. The only ‘known unknown’ is whether the political pressure on policymakers to change course has increased – or when it will do so – to a greater extent that the has difficulty of the choices to be made.
Predictions for 2012 and beyond
On the basis of this assessment, and adding in what we know about the broader global picture (some stabilisation in the USA at a low level, a substantial slow-down of growth in emerging markets from a high level), we can make some tentative predictions for the euro area in 2012. I put forward five ‘benchmark’ scenarios in what I see as declining order of probability. By ‘benchmark’ I mean two things. First, I exclude unpredictable, but far from implausible, ‘tail risks’, such as major oil price shocks as a result of the looming conflict in the Middle East. More importantly, these are stylised developments. Although each one is broadly internally coherent, there is of course scope for intermediate scenarios.
Scenario 1: Economic policy in the euro area continues as at present, but the economic situation worsens seriously, with the contraction in the periphery accelerating and recession spreading into the core. Fiscal ratios start to spiral out of control again. Unemployment rises. Protests grow in intensity. Faced with the deepening crisis and the likelihood of a major catastrophe there is finally a change of heart by existing policymakers and/or their replacement by disaffected electorates. Decisive policies are implemented that address the trinity of challenges and slowly start to resolve the crisis.
Economic and labour market outcomes in 2012 would be dismal, especially in the periphery. But a recovery would set in during 2013. The euro area would remain intact and policy changes would lead to an increase in the degree of policy integration between the euro area countries, including the setting up of new institutions, and not just ‘coordinated austerity’.
I consider a course of events along these lines – call it the death-bed-conversion scenario – to be the most likely. If I had to put a number on it, I would say about 50:50.
Scenario 2: Economic policy in Europe makes some small adjustments– e.g. additional ECB interventions in debt markets, some relaxation of austerity, helped by a benign global environment – that together do just enough to avoid a break-up of, or exclusions from, the euro area and a renewed serious downturn. The euro area remains intact but the economy stagnates, unemployment and fiscal burdens rise further in most countries. 2012 ends not much different from 2011, but the pessimism is deeper and welfare states weaker. Call this the bad-dream-continues scenario. I would give this more pessimistic scenario a probability of around one in three.
Scenario 3: Economic policy in the euro area continues as at present, but the economic situation worsens seriously, with the contraction in the periphery accelerating and recession spreading into the core. Fiscal ratios start to spiral out of control again. Unemployment rises. Protests grow in intensity. (So far as in S1). However, policy still stubbornly fails to change course. Some countries (Greece, Italy) are forced out of the euro area and the euro area breaks up. There are massive defaults on both public and private debt. The economy implodes due to the continued interlinkages between financial and economics linkages between the countries. There is widespread economic, social and political devastation in Europe and a world-wide recession. This is simply the worst-case scenario: It requires a degree of obtuseness on the part of policymakers that, even after the experience of the least two years, I still cannot imagine. But stuff happens: think of the First World War. Estimated probability: 10%.
Scenario 4: Economic policy in the euro area continues as at present. The economic situation worsens seriously in the periphery, but not in the core countries, where growth resumes as consumers and investors become more confident about successful fiscal consolidation. One or more of the peripheral countries is forced out of the euro area. Their populations suffer in the short run, but, freed of the euro, bounce back quickly thanks to the beneficial effects of depreciation. Freed of the dissolute members, the core countries have no difficulty maintaining a currency union broadly as envisaged in Maastricht plus enhanced fiscal surveillance. This is a sort of Hans Werner Sinn meets Paul Krugman scenario. Its probability is hard to judge.
I think a limited and orderly exclusion of some members with the recreation of a latter-day D-mark bloc is a pipedream held by many on the European right and a much smaller number on the (particularly American) left. No peripheral government will volunteer for this course, because the short-run economic and political risks and costs are so great. But they could be forced out by a suspension of external support, and that could happen quite quickly. Possible, but I think unlikely because most policymakers share my view that the associated dislocation would be huge (actually not much better than in S3). Devaluation is no panacea, threatening rapid inflation. For the sake of argument I will give this a probability of 5%. That leaves:
Scenario 5: European policymakers experience some sort of epiphany, or there is a change in leadership in the near future that leads to a change of course along the lines recommended above in the absence of a further substantial worsening of the economic situation beyond the already inevitable slowdown. Further crisis is avoided and by the end of 2012 Europe is slowly emerging, led by the core, followed by the periphery. Growth subsequently pick up, as pent up demand is satisfied; unemployment and deficits begin to fall.
Such a policy change is what I and many others have been arguing for for the past two years. It is economically eminently feasible. All actors would be better off. But from all we have learnt in the past two years and given the considerations above, the probability of this, the progressive-pipe-dream, scenario occurring in 2012, is – do the maths – very close to zero.