European Perspectives

Muddling Through: The ‘Realpolitik’of the Eurozone Crisis

It remains to be seen whether current policy tools can maintain economic momentum across Europe’s heterogeneous regions.

Rather than natural resources, geography or culture shaping a nation’s destiny, economists Daron Acemoglu and James Robinson propose a different explanation of economic growth in their book, “Why Nations Fail”. Essentially, they argue that man-made political and economic institutions are what actually decide a country’s fate.

According to their proposed framework, successful societies display four key characteristics: centralisation of political institutions, a clear division of competencies between centre and regions, democratically inclusive institutions and the willingness and ability to adapt to creative destruction. Applying this framework to the eurozone reveals a number of shortcomings: Political institutions are highly decentralised, division of competencies between centre and regions is skewed, eurozone citizens have learnt that policies are imposed from outside and low-skilled labour is ill-equipped to compete internationally.

The politics of crisis
Despite these shortcomings, the eurozone is doing better than what most critics predicted; yet, markets still assign a not-insignificant probability of a break-up. While equity indexes of core countries have broadly regained their 2007 level, share prices in southern Europe still languish about 40% lower and yields on 10-year government bonds are on average still 3% higher than in core countries. Whether these valuation differences are fundamentally justified or not depends not only on economics, but increasingly on the politics of the eurozone. Elections to the European Parliament in May 2014 and the formation of a new European Commission will be important milestones in shaping the future of both the eurozone and the European Union (EU). Concerning these visions, the political groups in the European Parliament can be divided into three main factions that we label the confederates, the status quo and the federalists. (See Figure 1.)

The dominant political groups prefer the status quo, believing that existing institutions and treaties suffice. In their view, to make the EU work better one simply needs to better utilize the existing treaties. The confederates, meanwhile, aim to take back powers from the centre and return it to the national level. For example, some members oppose immigration, while others would like to dissolve the euro altogether or even leave the EU. Finally, the federalists believe Europe in its current form will not succeed. For the euro to endure, federalists promote transferring more power to the centre, strengthening the democratic legitimacy of European institutions and equipping the eurozone with a risk sharing tool. However, as they outline in their manifesto, “A Fundamental Law of the European Union”, this would require major changes to the treaties.

Factions aside, satisfaction with the euro is decreasing. According to the Eurobarometer survey (see Figure 2), only 51% of survey respondents now support the euro, while an increasing proportion, 42%, disapprove. Although the confederates, including EU and euro sceptics, only make up about 20% of European Parliament votes today, this faction looks set to gain a larger share in next year’s election.

Fortunately, the status quo faction, with an almost two-thirds majority of the European Parliament, will likely remain the largest faction after next year’s election. The increasing polarisation among confederates can also be expected to bring the status quo and federalist factions closer together. The legitimate question remains whether current policies will suffice to end the euro crisis. No one knows ex ante with certainty; but with such heterogeneous countries in the eurozone, we would venture a negative response.

Progress overshadowed by justified doubts
We must acknowledge that status quo policies have already achieved a lot. The current account balances of peripheral countries have increased to a surplus of 1.5% of GDP, up from a 6% deficit in 2008 (see Figure 3). Even Greece now runs twin current account and primary surpluses. Likewise, unit labour costs have fallen, especially in the periphery, and structural reforms are being implemented.

To date, Greece, Spain and Portugal have been the most responsive countries to implement structural reforms recommended by the Organisation for Economic Co-operation and Development. The significance of the new fiscal and surveillance tools – known as Two-Pack, Six-Pack and Fiscal Compact initiatives that give the European Council a de facto veto right over national economic policies – is probably underestimated by global financial markets. And the Single Supervisory Mechanism, designed to deliver greater centralised supervision of major banking institutions in the eurozone, is a done deal.

Still, although progress has been achieved, four main doubts linger on: social stability, cyclical versus structural change, distrust of inter-government agreements and over-reliance on the European Central Bank (ECB).

The adjustment of external balances came at the cost of increasing unemployment to just over 12 million persons, predominately in Europe’s periphery (see Figure 4). In Spain and Italy alone, the number of unemployed almost doubled to more than 9 million over the last five years. High and long-term unemployment is a tinder box for the permanent atrophy of skills and social unrest. For example, it was violent social unrest that helped tip Argentina to default in 2001. The increasing political radicalisation of violence in Greece should serve as a siren call that there are limits to internal devaluation and social tolerance.

Although external trade balances in the periphery have improved since the height of the global credit crisis due to a cyclical contraction in domestic demand, we do not yet know whether growth models in these countries are changing structurally. It takes time for labour and capital to shift from unprofitable to profitable sectors, and from non-tradable sectors to exports. So the question remains whether these countries are able to grow and maintain their external surpluses.

At the same time, investors have little evidence to trust policymakers to do what the rule book says. Member states – Germany and France in particular – broke their budget promises under the eurozone’s Stability and Growth Pact, while the no bail-out clause was broken. It is doubtful whether new inter-governmental agreements will be effective without assigning cross-border powers over national budget and economic policies to the European Parliament or a senate representing the eurozone countries.

In a monetary union, individual countries’ fiscal policies and labour markets need to be all the more robust to make up for the loss of exchange rate flexibility. This means even higher primary balances and more flexible labour markets are prerequisites for stability. Throughout history, no monetary union has survived without either transforming into a complete political and fiscal union or eventually breaking up. Markets are therefore too complacent if they think the stability purchased by the ECB will last forever.

Nevertheless, muddling through looks set to continue in the next legislative period of the European Parliament. The status quo faction will seek to exploit the untapped potential of European treaties. The European Council will appoint the next president of the European Commission, taking into account the results of the upcoming European Parliament elections, thereby increasing the democratic legitimacy of the European Commission and binding it closer to the Council. The Single Resolution Mechanism, an integral part of the banking union, will be put into place and is expected to come into force by January 2015. Greece and its public sector creditors are likely to agree on debt restructuring by further reducing coupons and extending maturities. And by 1 January 2018, the European Fiscal Compact legislation will be included in the European treaties.

Status quo PLUS
So what if muddling through fails? The European Stability Mechanism (ESM) has a lending capacity of €500 billion, about three times the size of the EU’s annual budget. If growth in the eurozone disappoints, ESM resources, with shareholder approval, could be mobilised for countercyclical fiscal policy. We call this the “status quo PLUS” policy that could be activated if muddling through fails to spur growth and stabilise sovereign debt.

Investment implications are two-fold: The political will behind the euro is strong enough such that redenomination risk from the euro to legacy currencies is de minimis. Status quo and federalist policies are likely to come closer together over time. First, we believe the risk for government and corporate bonds with maturities of up to three years that sit under the umbrella of the ECB’s pre-committed liquidity policies to be low and may therefore serve as an attractive basis for participation in periphery country assets. And second, for securities with longer maturities and lower down in the capital structure, caution is required as with all riskier assets. Sovereign debt restructuring in Greece and growth headwinds put question marks on the sustainability of Portugal and Italy’s debts. But given the structural adjustments that are occurring, bank bail-in rather than bail-out and the possibility of status quo PLUS policies as a backup, today’s price levels already compensate investors for taking some additional risk.

The Author

Andrew Bosomworth

Head of Portfolio Management, Germany

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