It is in times of adversity that we know our true friends. Having slipped back into recession and plagued by record-high unemployment, the European Economic and Monetary Union (EMU) managed to strengthen its ties, if not in terms of friendship then in terms of governance. The first big step was taken at the Eurozone Summit on 29 June. By opting for a banking union, the eurozone heads of state and government ratified the principle of sharing risks already written into the European Stability Mechanism (ESM). For once, a community-wide logic won over that of individual countries. If all goes as planned, it will no longer be up to individual governments but to European institutions to restructure the weakest banking institutions. This would be achieved through joint supervision provided by the European Central Bank (ECB) and through capital injections or guarantees provided by the ESM. This supranational architecture is designed to break the vicious circle of sovereign and banking risks. All that is left now is to get things started: France favours the fullest banking union as quickly as possible, Germany less so.
And yet, it is about time. Since the beginning of the crisis, with the renationalisation of debt, troubles have tended to concentrate on the banks of the peripheral countries. In southern Europe, bank risk premiums have widened in keeping with the spreads on government bonds, fostering destructive hedging activity and market segmentation. Over the summer, not only Greek banks but their Spanish and Portuguese counterparts were all hit by capital outflows. Credit contracted even as it continued to expand everywhere else. As the recession worsened, growth estimates had to be downgraded and deficit forecasts revised upwards. There was a tangible threat of debt to deflation mechanism, in which spending and revenues drag each other down into an endless spiral. It became urgent to reduce spreads.
On 6 September, the ECB assumed its responsibilities by announcing plans to purchase unlimited amounts of short and medium-term bonds from eurozone member countries on condition that they first adhere to an adjustment programme. This conditionality, and the acceptance of pari passu (no seniority) with regard to private creditors, creates a strong incentive to reinvest in the discounted debt compartment, at least as far as Italy and Spain are concerned. By the end of September, the two countries had returned to acceptable conditions for market financing. But now what? It would be wishful thinking to believe that a simple announcement effect could eliminate the financial tensions threatening the eurozone. The risks will only subside if they are assumed collectively, which implies official securities purchases. For the moment, the Spanish government is loath to call on outside assistance due to the counterparties that would entail. But it has no other choice. Despite its efforts, the Spanish deficit will be close to 7% of GDP in 2012, and its debt expansion will not be curbed enough to reassure investors.
Spain’s hesitations raise the thorny question of how to gauge support packages correctly. To remain credible and to avoid undermining the institutions that provide the bailout, support packages must be accompanied by restrictive measures, often structural ones, to reduce deficits. But to be effective, it is also important that they do not destroy growth. If we call into review the therapies prescribed so far by the Troika of lenders (the European Commission, ECB and IMF), we can conclude that they have demanded too much too quickly. The fiscal multiplier, i.e. the negative impact of austerity measures on activity, was underestimated. In an April 2012 study, the IMF found that this multiplier tended to rise when the economy was operating below potential. Financial constraint, high unemployment or simply a bad environment would make people adopt a more precautionary savings behaviour. Both households and companies are more inclined to sacrifice spending when deficit reduction measures cut into their disposable income. This increases the depressive effect.
Paradoxically, Europe is beginning to reconsider the right dosage for austerity just as it has equipped itself with a stronger fiscal treaty (the fiscal compact). Portugal is a textbook case. A good student but deprived of growth, the country will not meet its 2012 targets. Missing its target of 4.5% of GDP, the public debt ratio will approach 5%. But beside seeking additional adjustment measures, Portugal’s creditors have acknowledged the overrun and pushed back the timeframe for bringing it below 3% of GDP until 2014. The same can be said for Spain: in July it was given more time to meet its targets.
For the eurozone’s peripheral countries, the pressure has eased and the horizon is not so gloomy. Their external accounts and competitiveness are improving, a change for the better that is worth supporting.
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