European leaders are expected to agree on a ‘comprehensive plan’ to deal with the spiraling crisis of the euro. The final document will derive from the upcoming summit on October 23 and for the time being many technical details and other parameters remain unknown. From the information available it seems that it will include provisions to restructure the Greek sovereign debt, recapitalize private banks, expand the funding capaicty of the EFSF.
In the midst of all the bargaining that is taking place on the backscenes of European politics as every one prepares for the summit, it would be useful to have a look at the current environment in the eurozone to understand how difficult, yet absolutely essential, it is to agree upon a comprehensive package that will stem the crisis.
The environment in which the summit will be held is quite bleak and the issues that need to be addressed are multifaceted. A depiction of the economic and political situation in the euro area will allow us to appreciate where the eurozone currently stands and what challenges policy-makers face.
The economic situation:
- Many European banks have been in a zombie condition for long now, retarding growth by absorbing all the liquidity that is thrown their way. Their underlining insolvency was never addressed and thus they have been acting like black holes to the system (see Dexia zombie bank: The tip of the iceberg and the derisory stress tests)
- Greece is insolvent and will sooner or later have to restructure its debt, with haircuts on private creditors reaching 50% or more. An exit of the country from the euro is economically self-destructive and politically impossible. Any plan about the fate of Greece must be within the context of the single currecy (see Currency union and Greek Euro Exit and also Exit of Greece from the euro is nonsense).
- Portugal and Ireland, have qualitative differences between with the former being in a more difficult position than the latter. Yet both remain vulnurable to any volatility in the rest of the eurozone and therefore can easily fall back into serious trouble should the situation deteriorate.
- Italy and Spain are solvent but lack liquidity, which raises fears about their capacity to finance their short-term needs. This effectively leads to a self-fulfilling cycle where the expectations of default lead towards that direction. The two countries have practically lost market access however this is not visible at the moment thanks to the contast intervention of the ECB, which can only buy time until a stable solution is found.
- Belgium and France are both solvent and have no liquidity problems (for now), but their private banks are seriously exposed to the debts of the European South, which suggests that the amount of capital that needs to be pumped into these banks is considerably higher than that of other countries. Should such a task be left to be dealt with at a national level both Belgium and France will have a hard time recapitalizing their banks, as they will effectively further worsen their already unstable public finances. This will most probably result in downgrades from the major credit rating agencies. It is fundamentally important to realize that if France loses its AAA credit rating then the EFSF, which largelly depends on France’s credit rating, will fall into jeopardy, taking down with it the programmes in Ireland and Portugal and whatever other task might be assigned to the region’s bail out fund.
- The surplus countries of the area, Germany, the Netherlands, Austria and Finland are in a much better position and in fact are the only countries that still have an option that others do not: they can bail themselves out of the euro should things go for the far worse (even though this is not what they wish to do and this is not an optimal choice). However the overall slowdown in the global economy and the recession in the European periphery has reduced aggregate demand for their exports.
- Inflation in the euro area has remained high and has now reached 3% according to the latest eurostat report. The ECB needs to maintain a hawkish approach by keeping main interest rates at least stable, however this will further worsen the liquidity issues of Spain and Italy (see Evaluation of inflation and unemployment amid the Euro Crisis).
The political situation:
- Regardless of how cynical this might sound, the crisis is seen as a unique opportunity to push for the most radical reforms in countries that have been unwilling to implement the necessary changes over the last years/decades (the shock therapy approach). In practical terms, the immense pressures that arise from the prospect of default in Greece first and then in Portugal, Ireland, Italy and Spain give the power to the rest of the eurozone countries to use their economic support as an incentive to demand much needed reforms.
- Germany, Netherlands, Austria and Finland possess immense bargaining power over the rest of the countries, because of their much more favorable economic position. On the other hand countries like Italy and Spain, despite the fact that they are the 3rd and 4th largest economies of the euro do not even dare to think of speaking their mind as that could easily produce adverse effects in the markets, leading interest rates to new heights, making their position even worse.
- Because of their inability to make propositions, these two countries are trapped in a position where they cannot have any practical impact on political decisions and on the other hand must implement austerity measures that further worsen their economic situation by contracting their economy. Austerity needs to be implemented for the sake of showing compliance to the hard line of the surplus countries and for appeasing the markets, since inaction would be conceived as a sign of inability to deal with fiscal issues, again leading to uncertainty and unrest which would affect interest rates on sovereign bonds (see The ECB captivity and the Italian, Spanish and Belgian prisoners).
- Greece is treated in a way that causes excruciating pain to its society. The harsh treatment is used as a detterant to any other country, sending a clear message that reforms must take place to avoid the suffering Greece is forced to endure. It is crystal clear that the demands of the ‘troika’ from Athens go against any economic reasoning and even though most can agree that reforms are more than necessary no sensible person would offer her consent to the sort of austerity policies the troika’s officials put forward. The malignancies of the Greek economy-society-state are deep seated and need to be addressed in their totality. Yet this must be done in a way that does not kill the patient.
The above form the environment in which European leaders are called to agree on a plan to deal with the crisis. An objective observer might be led to the conclusion that Europe is unable to solve all of its problems since what might pose as a solution to one is in fact a problem for the other. Indeed the multi-dimensional issues and the overall complexity of the matter give the impression of clashes of interest in more than one occassion. However such a conclusion would have been logically flawed and a serious misunderstanding of the fundamentals of the crisis of the euro.
What we are facing in Europe in not a series of perfectly separable issues. All of the above are interconnected and all trace their roots in the systemic nature of the euro crisis (see Full analysis of the Euro Crisis). The only way to deal with the challenges ahead is to abandon the current understanding that treats the crisis as an amalgamation of otherwise individual cases that can be dealt with on a case-by-case basis. We need a system-wide approach instead that will take into account all of the above. Such an approach is feasible and there are a series of steps that can be taken towards that direction. What is required first and foremost is political willingness and hopefully this will exist on the following summit, given the severity of the moments.