Over the past year, Europe has enjoyed calm financial markets. At the core of the market’s comfort were two assumptions about policy. First, that the European governments would do just enough to keep the process of European integration moving forward. Second, that the ECB would, in the words of Mario Draghi, do “whatever it takes” to save the euro. The centerpiece of the ECB’s subsequent efforts was expanded liquidity (through long-term repurchase operations and easier collateral requirements for banks to access ECB liquidity) and a commitment to purchase government bonds to support countries return to market (the OMT program). Even many pessimists who fear that Europe is trapped on a unsustainable, low-growth trajectory remain optimistic that Europe will do what it takes to navigate the near term risks. It may be time to question that optimism.
As many have noted, there is an increasing sense of adjustment fatigue in Europe, reflected in pressure on governments and the rise of anti-austerity, anti-establishment parties across the Eurozone. In rhetorical terms, Europe has responded, and fiscal policy looks likely to be broadly neutral in the year ahead. However, an overall fiscal relaxation that is needed in the euro area as a whole looks unlikely, as peripheral countries can’t afford much additional spending, while the core countries that can spend more seem disinclined to.
Monetary policy also falls short of what is needed to establish the conditions for growth. Unlike the United States, where a decision to recapitalize banks was coupled with strong Federal Reserve easing policies that established the basis of recovery, the ECB has to date resisted quantitative easing or a significant easing of collateral requirements to spur lending to small and medium enterprises (SMEs) in the periphery. While it’s fair to point out that the ECB faces a more constraining legal and governance framework than the Fed, it’s also hard as a result to be confident in the IMF’s (and others) view that recovery is coming to Europe in 2014. Even the IMF acknowledges that currently, “centrifugal forces across the euro area remain serious and are pulling down growth everywhere.”
Finally, there seems to be little political consensus on creating a true banking union (with deposit insurance and a strong pan-European resolution authority), dealing with the legacy sovereign debt, or honestly addressing the scale of the non-performing loan problem. All these are critical to a long-term solution to the crisis. All of these are long-term pressures on Spain, France and Italy, on which the future of the Eurozone no doubt rests.
However, in the coming months Europe will face tests from a number of smaller countries. Notably, economic programs in Greece, Cyprus and Portugal are all heading off track. In the case of Greece, money promised for later years has been moved forward, resulting in a financing gap that will be impossible to ignore at the next review of the program in September. Cyprus will need expanded ECB access if it is to ease capital controls. Each of these countries will require new programs with more money, and eventually a debt restructuring. Reviews of these programs in the fall likely will be too early for Europe to agree to debt official debt reduction, but fresh new money with an unsustainable debt profile may be similarly hard to justify. Meanwhile, Ireland looks ready to press for better treatment on its debt as well.
In each of these cases, the argument has been made that concessions cannot be made to these countries ahead of German elections in September (and a German constitutional court ruling on the ECB’s bond-purchase program). This of course creates expectations that things will be much better for these countries after elections. There is talk of a December European leader’s meeting being the forum for a “move towards more Europe.”
The problem is not the scale of the support needed in each cases. These are small programs that can readily afford to be expanded within the existing framework. The problem is that they could become the place where broader battles over the future of Europe–on official sector debt reduction, on banking union, and on fiscal federalism—are fought out. In that case, will existing ECB liquidity facilities and the threat of OMT be enough to keep markets calm? If pressures on banks or governments intensify, questions will no doubt be raised on whether the ECB’s threat to buy bonds is a bluff. It’s hard to imagine countries accepting material new conditionality to access the bond-buying facility, or that the ECB could materially ease its conditions for use. The period of financial market calm may be coming to an end.