Eurocrisis: Do not underestimate complacency

2012-03-28

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There is room for cautious optimism. But always beware of complacency.

Many have already said that the crisis in Europe is practically over, since the tensions in the banking system have been relaxed thanks to the LTRO, the Greek crisis has been contained with the second bailout, confidence has been restored with the signing of the fiscal compact, while the final details need to be sorted out on the ESM, the “firewall” that will ultimately protect Italy and Spain from contagion. Though it is indeed a fact that things have been relatively calm lately, the claim that the crisis is practically over is perhaps too optimistic if not slightly unrealistic.

Of course when people like Mario Monti, the Italian Prime Minister, or Angela Merkel, the German Chancellor or even Mario Draghi, the chief of the ECB, or any other of European leaders, say that the difficult part of the crisis is over, they have good reason to do so, since the restoration of confidence in the euro area will eventually reduce borrowing costs and alleviate much pressure on policy-makers, thus removing many of the obstacles towards recovery. For them being optimist is part of their responsibility otherwise they would be undermining their positions, something too reasonable to analyze or challenge.

Though I would like to share this optimism, since I really wish this crisis will end sooner rather than later, for the sake of all of us; I cannot afford to do so. There are several issues that remain unsettled, while many of the problems have only been pushed under the surface, where they can grow without anybody noticing them.

To point out the most important of these issues, the second bailout programme for Greece will only be sustainable and successful if a series of conditions are met. If for instance the local political establishment is willing to implement more austerity measures and take unpopular measures. Towards that end much will depend on the results of the upcoming national elections that will most probably give rise to a highly anti-troika parliament that will have little appetite for the directives of the troika or the “task force”.

Next, the programme in Portugal does not look in a very good shape and there are many indications pointing to an inevitable debt restructuring of the Portuguese sovereign debt, possibly complimented by additional funding, some time between the end of 2012 and mid-2013.

In addition the situation in Spain is as bad as ever. Even though borrowing costs had decreased, due to the ECB’s LTRO programme, many of the internal malignancies and structural flaws remain in place. The property bubble has not been resolved nor has unemployment been addressed. Even if the Spanish government were to minimize deficits in order to control its debts, the existing mountains of private debt might renew the negative feedback loop between banks and sovereign, especially now that banks are even more exposed to Spanish debt (see LTRO has exacerbated systemic risk – Draghi did not reverse the crisis).

Finally the real economy will have a hard time recovering, given the ongoing rigidity in the money supply. Moreover the prospect of Euro-wide protectionist policies or red tape measures will impede the efforts to bring the European Union back to a sustainable path.

Given the above, I uphold that we need to remain cautious about the future. Short-term relief is not equivalent to market confidence. The economic situation of the eurozone remains fluid and many things can change before the crisis is finally killed off. European leaders have good reasons to be optimistic, but we need to remember that similar optimism prevailed nearly two years ago, when Greece was bailed out for the first time and the Greek finance minister was arguing that Greece would enter the markets the latest by 2012.

It is of course to the interest of all well-meaning parties to solve the problem, but never underestimate complacency.