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Solving the quintuple euro crisis: is there still a way out?

In this article, we look at the construct of five different crises supporting the ongoing Eurozone turmoil. In order to conquer the chaos, we must first battle a sovereign debt crisis, a banking crisis, a growth crisis, an institutional crisis and a political crisis. Can we find an escape route from the quintuple euro crisis?

From small crises…

Over two years ago, it became clear that the Greek government was running much higher deficits than previously acknowledged – the country was on the verge of bankruptcy. It took some time for Eurozone leaders to react but eventually they installed a firewall in the form of the European Financial Stability Facility (EFSF). At the same time, Greece was obliged to implement structural reforms to make its economy more flexible, restore the country’s competitiveness and bring down its government deficits and debt.

Unfortunately, the conditions attached to the financial aid provided by the Troika (the collective term for the European Commission (EC), the International Monetary Fund (IMF), and the European Central Bank (ECB)) were so stringent that they undermined the economic growth potential of the country under auspices. While the structural reforms were introduced to enhance Greece’s potential growth, they arrived with high short-term costs that served to depress growth even further. Consequently, the Greek sovereign debt crisis quickly translated into a growth crisis and a deeper, more prolonged recession means that the country’s debts are weighing more heavily than ever. Factoring in the bank losses that are the result of the ailing economy, the negative spiral deepens further as banks are unable and unwilling to extend the credit necessary for the country to grow.

…to a ‘too big to fail’ dilemma

Fast forward two years. Following the crises in Greece, Portugal, Ireland and Cyprus, the problems have clearly spread to Spain and Italy, even though this is what Eurozone leaders always tried to avoid. After all, Spain and Italy were not only believed to be ‘too big to fail’, but also ‘too big to bail’. In other words, if Spain and/or Italy get to a point where they can no longer keep their own heads above water, not only do the core countries not have the financial muscle to keep these countries afloat, but the third and fourth-largest euro economies will also bring the entire euro structure down with them.

Economically speaking, the contagion that spread to Spain and Italy could have been avoided. What was needed was a much larger firewall than the EFSF and European Stability Mechanism. Speedier economic reforms and a looser monetary policy as a counterweight to the fiscal tightening in the peripheral economies were also required. ECR believes that the Eurozone would not be in the position it is now if the following strengths were visible to the European landscape – before investors started doubting Spain and Italy’s creditworthiness:

  • Spain and Italy showing they were willing and able to do what was necessary to make their economies healthy again.

  • The core countries demonstrating their willingness and ability to provide the necessary bridge financing as the peripheral countries went through a difficult phase.

Unfortunately, Eurozone leaders have been doing ‘too little, too late’; each time the crisis entered a new phase and tensions in the financial markets threatened to close down access to the capital markets for a weaker member of the single currency union, the European authorities reacted with a force that was far weaker than was actually required. There is only just enough financial assistance provided to keep the weak euro members on their feet, but a clear resolution plan is lacking.

Worsened by political and institutional crises

Underlying this ‘too little, too late’ stance is a political and institutional crisis. The institutional crisis has to do with the fact that the Eurozone did not have the necessary tools to combat the sovereign debt, banking, and growth crisis in the first place.

When the monetary union was formed, a mechanism to deal with a country experiencing government debt issues was deemed unnecessary as all countries should have adhered to the 3% government deficit and 60% debt limits laid out in the Stability and Growth Pact. When they did not, a sovereign default evolved from being a distinct possibility to a dark reality. Today, the only way out seems to be a fiscal union whereby debts are shifted from those who cannot shoulder them to those who can – be it in the form of Eurobonds or not.

What complicates the situation further is the fact that banks are being supervised by a national authority, even though they are operating cross-border: it is in the country’s interest that the banks’ domestic activities do not threaten domestic financial stability but the problems of subsidiaries across the board are of little concern. Thus, cross-border banks are not efficiently supervised and there is no clear plan as to what would happen if such a bank fails. Additional financial instability is the result, and a banking union is urgently needed to solve these issues. Making the ECB the common supervisor is the first step in this direction – but we have not yet reached this point. Moreover, a common deposit insurance guarantee scheme is required to give depositors of weaker banks the feeling that they are not at risk of losing their savings.

As the peripheral countries (especially) were experiencing subpar growth, wages grew much faster than productivity (which resulted in a loss of competitiveness) and government spending became an ever larger yet unsustainable part of the economy. There was no European authority to step in and force these countries to focus on restoring their competitiveness and the core countries continued to finance the extravagant lifestyle of their southern neighbours. A political union is therefore required, whereby European authorities can take control if a country is implementing unsustainable and unhealthy policies.

Another cause of the ‘too little, too late’ stance is that there are not enough determined leaders willing to bring across unpopular messages to voters. In the core countries, the content of the message should be that keeping the euro requires more financial sacrifices, for example, the debts in the peripheral countries are too high and need to be written off – at least partly. Structural reforms take time and undermine short-term growth, so to avoid pushing the weak countries over the financial precipice, they need further aid. At the same time, it has to be acknowledged that Spain and Italy are not sitting still and they are already implementing some tough austerity measures. To set the peripheral countries on a healthy growth path and make them solvent again, a long-term road map toward a banking, fiscal and political union is no doubt required. In turn, this would go a very long way in addressing the quintuple crisis.

Addressing the quintuple crisis

The big question is whether all this remains hypothetical speculation rather than an impending eventuality. With growth in the entire Eurozone slowing, the willingness and ability of the core countries to stand behind the peripheral countries is declining. At the same time, with Hollande’s policies going in the opposite direction of what Merkel prescribes for the peripheral countries, Merkel has lost an important ally and the peripheral countries have gained one. This does not bode well for the euro: the focus has shifted much more towards short-term pro-growth policies and an enhanced role for the ECB rather than policies and a road map for the future that would ensure the long-term viability and growth potential of the Eurozone. It also means that doing ‘too little, too late’ remains the path going forward, because leaders will only embark on the necessary austerity measures if the financial markets give them no other choice.

A sense of solidarity is needed to make the Eurozone project work again, yet we are now drifting in the opposite direction. The opposition against more integration and more financial aid (with strings attached) in virtually every euro country is growing.

What we can expect is ongoing and worsening crisis phases, with upward pressure on the government bond yields of the weak countries and downward pressure on the yields of the strong countries – at least until politicians give up resistance to announce a viable long-term plan in the form of a banking, fiscal and political union. For a more detailed vision about interest rates and exchange rate, please sign up for a free trial via the ECR Research website.

Chart 1: Spain and Italy are still treading dangerous territory: Ten year government bond yields too high to be sustained.
Chart 1: Spain and Italy are still treading dangerous territory: Ten year government bond yields too high to be sustained.

Source: Thomson Reuters Datastream/ECR