On January 1st, German Chancellor Merkel said she will do “everything” to save the Euro and bring an end to the on-going European debt crisis. Global investors, weary, skeptical, and worried, wonder if the eurozone will survive another year.
The eurozone was flawed since its inception. The Euro was established by the provisions of the Maastricht Treaty 20 years ago. The Treaty was an important step in the process of post-WWII European integration to unite 17 dissimilar member states with one common European currency to form a powerful and integrated European economy. The hope was that the economies of eurozone member states would become similar over time, “converge,” by setting the Maastricht economic criteria as common goals. Today member states continue to be dissimilar economically, politically, and culturally. The fundamental problem in the eurozone today is well-understood: The “peripheral” eurozone countries are not able to compete economically with the “core” eurozone countries. This is a problem of such magnitude that it cannot be resolved by policymakers within the framework agreed to at Maastricht 20 years ago. Exposed by the global financial crisis, the eurozone was flawed since its inception.
The eurozone debt crisis isn’t getting better; it is getting worse. The world’s biggest economic risk for 2012 is the on-going Euro sovereign debt crisis. In what appears to be a global economy that is recovering from the global financial crisis, the eurozone remains burdened by too much debt, with recessionary levels of economic growth, and an EU political process which can’t seem to solve the sovereign debt problems nor instill investor confidence. Throughout the years of the crisis, investor optimism has risen in anticipation that the emergency EU summits would find a solution, only to result in investor disappointment. As euro-pessimism grows, global investors flee peripheral European markets. The eurozone debt crisis is getting worse.
2012 appears to be the critical year. The magnitude of the debt problem is increasingly daunting. The current outlook is that the effort to keep the eurozone together will be won or lost in the current battle to save Italy and Spain from the burden of their debts and deficits. These are two countries that have economies that are too big to fail without destroying the eurozone in the process, while also being too big to rescue, as there is not enough money available to cover their financing needs though “bail-out” funds. The challenges are imminent, as Italy and Spain’s pressure for financing in the bond markets this year starts in January. The world is watching to determine if they are able to borrow at affordable and sustainable rates. With investor confidence low and fragile, the question for 2012 is if the eurozone will integrate or dis-integrate economically.
The newly proposed EU treaty will not solve the debt problems. German Chancellor Merkel expressed in November that “It is time for a breakthrough to a new Europe.” Germany, the economic powerhouse of Europe with corresponding political influence, was the creative force and dominant influence of the Dec. 9th EU summit which will result in a new treaty in 2012, once detailed and ratified. The new treaty will reflect the German viewpoint that further fiscal integration is the next step in economic integration and that it will be accomplished by stronger management of fiscal austerity and penalties for those countries that don’t comply.
Italy and Spain are moving quickly to comply, to cut deficit spending, and to make their countries more competitive and productive, an on-going and painful process. In the case of Italy, Prime Minister Monti passed an emergency budget plan to overhaul pensions and address tax evasion, and will likely soon address the sensitive topic of labor market reform, how to ease the laws on the firing of workers. Meanwhile, in Spain, newly elected Prime Minister Rajoy is raising taxes, pledging further labor market reform, embarking on a new round of financial sector reforms, while also addressing the politically difficult to manage regional budget deficits.
It is a positive development that the new treaty will bring more fiscal unity to the eurozone by addressing one of the fundamental problems of the Maastricht Treaty, the abuses of excessive government spending. The new treaty makes a noble attempt to distinguish between government spending which is “excessive” and that which is “necessary” during the economic cycle to stimulate growth. However, EU leaders continue to receive criticism for relying on fiscal austerity because cutting government spending abruptly can provoke further recession and make debt management more difficult. In a year-end comment, the IMF Chief Economist wrote that fiscal austerity, when combined with lower economic growth, could actually lead to an increase, not decrease, in spreads on government bonds. Austerity measures alone are not certain to result in lower yields on government debt.
Credit agencies have already expressed doubts of the new treaty as planned by warning of many further sovereign credit downgrades, including France’s AAA rating. Financial market reactions are mixed, but with Italy’s benchmark 10 year yields still hovering near 7%, financing costs are still considered too high to be manageable over time. Spain has seen an improvement on bond yields, though it may also prove to be transitory. As a consequence, peripheral bond markets remain vulnerable to losing further investor confidence, more capital flight, and rising yields, all of which make debt management less sustainable. In short, even after the newly proposed treaty, it doesn’t seem that anything has really changed.
2012: Integrate or dis-integrate.
Investor confidence is at a critical point. The eurozone was built upon the euro optimism of the 1990s that propelled huge capital flows into the peripheral countries, “the high yielders” of 1990s, with the hope that economic convergence would follow. However, there continue to be great disparities between the competitiveness of the peripheral countries with that of the core countries. Today euro-pessimism has the grips on global investor sentiment, driving capital from peripheral countries into the core euro countries and other non-European countries.
Lack of investor confidence and dis-investment of the periphery will continue in 2012 in the absence of true changes to the underlying economic foundation of the eurozone. Improving a country’s productivity and competitiveness certainly won’t be resolved nor finished with the current measures being undertaken in Spain and Italy. EU leaders have not been able to propose convincing policy measures in recent years, and the new treaty, as proposed, does not provide compelling evidence that will change. Much more significant and comprehensive changes in the governance of the eurozone will be required to inspire investor confidence to dispel euro-pessimism and capital flight.
None of the truly transformational measures that have been proposed have been acceptable to Germany. Germany’s unwillingness to accept measures to share the economic burden of weaker countries, though understandable, also gives global investors less reason to believe that the eurozone debt is manageable. Although Germany has not yet accepted the idea of Eurobonds, jointly issued bonds that spread the credit risk across the eurozone countries, they may eventually be required to save the eurozone if Italian and Spanish yields are determined to reach unsustainable levels in 2012. The European Central Bank, in spite of recent drastic measures to provide liquidity to a fragile banking system, may also need to have a broader mandate that allows for the direct purchase of sovereign bonds from peripheral countries to support bond prices and to inspire global investor confidence. New EU treaties and German support would be required on any of these measures to fundamentally transform the eurozone, none of which are anticipated at present.
In the absence of such transformational revisions to the governance of the eurozone, the current trend towards a stronger, smaller, eurozone will continue in 2012. While tighter fiscal integration will create a smaller, more deeply integrated eurozone, the financial markets and investor sentiment will continue to punish weaker countries with still higher yields resulting in unmanageable debt and deficits. If these countries fail to borrow at affordable rates, the dis-integration of the eurozone, losing weaker countries from euro membership, is certainly possible, if not probable. Though there is no apparent reason to celebrate the 20th anniversary of the Maastricht Treaty, if the eurozone averts disaster in 2012, there will certainly be reason for relief.