Hamish McRae: Eurozone is being stress-tested, but it will not break apart easily

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The European leaders duly gathered in Berlin yesterday. The aim apparently was to move towards a common approach at the forthcoming Group of Twenty economic summit in London in April: what to do about the global downturn. But actually the ghost at the feast was not what is happening to the world economy, which is in fair measure beyond their control. Rather it was what has been happening within their own jurisdiction, within Europe and in particular within the eurozone.

The problem, at its simplest, is that economic divergence within the eurozone has increased rather than diminished since the single currency was adopted, with the result that the current accounts have become more out of balance. Government finances have also diverged to such an extent that weaker governments are having to pay much more for their borrowings than stronger ones.

In the boom years these strains were not so evident, but now they are to such an extent that the markets are openly considering the need for the weaker countries to be rescued by the rest of the EU. The consequences of not doing so might either be a European government defaulting on its debts, or even the break-up of the eurozone itself.

Weakness in Eastern Europe has given a further twist. While the new member states (with the exception of tiny Slovenia) have yet to adopt the euro, the exposure of economies such as Greece and Austria to these countries has created further strains. Austrian banks in particular look vulnerable.

So it is a mess. But how big a mess? Start with the imbalances. One of the inevitable consequences of the single currency has been a single interest rate. For some countries, most notably Germany, that rate appeared too high. For others, such as Spain, Greece and Ireland, it was probably too low. But Germany knuckled down and contained its costs; as you can see in the chart, German unit labour costs rose by less than 5 per cent during the past decade. By contrast Italian and Spanish costs rose by more than a quarter, and Greek costs by more than 35 per cent.

Unsurprisingly the current accounts moved in the same direction, as the other chart shows. Back in 2001 Germany was in current account balance. In 2007 it has a surplus equivalent to nearly 8 per cent of GDP. Italy moved from being close to balance to a deficit of 2.6 per cent of GDP. But that deterioration was dwarfed by that of Spain and Greece. Spain went from a deficit of just under 4 per cent to one of more than 10 per cent, while Greece went from a little over 7 per cent to more than 14 per cent.

The other side to this coin has been the deteriorating confidence in the governments of the weaker economies. Two years ago Italy and Greece paid only about 0.25 per cent more than Germany for a 10-year bond. Last month Greece was paying 2.2 per cent more and Italy 1.3 per cent more than Germany. That sort of premium is not nearly as large as the premium Italy or Greece paid before they adopted the euro – in the middle 1990s Italy was paying 6 percentage points more than Germany – but it shows how nervous the markets have become.

So what will happen? The first point to make is that there is such huge political commitment to maintaining the euro that it will not break apart easily. But the cost to a country staying in the eurozone will be high too. I have been looking a two bits of analysis of the likely outcome: one from the Centre for Economic Studies (CER), which is broadly supportive of the venture, the other from Lombard Street Research, which has been generally critical of it.

The CER paper, written by Simon Tilford, suggests that the most likely outcome will be that the hardest-hit countries will be forced into a sharp fiscal adjustment. Ireland is doing that now, with the unrest we saw at the weekend. The problem with this is that it will deepen the recession for those countries, and if that happens it will be self-defeating as the required fiscal improvement will not occur. The more the stronger economies are able to boost output the greater the help they will give, but the most likely outcome will be weak eurozone growth and prolonged stagnation in some member-states.

The paper also sketches other possible outcomes, including the least likely: faster integration within Europe. Others include: a bailout of the weak states by the strong; some countries defaulting on their debt but keeping the euro; and some defaulting and leaving the eurozone altogether.

The other paper, by Gabriel Stern, points out that the crisis has eroded many of the perceived advantages of staying with the euro, raising the possibility that some countries might leave. Though the short-term costs of leaving might be higher than staying in, the longer-term advantages would outweigh that. That is because the pain of adjustment is likely to be greater for countries in the eurozone than for those outside it. The author’s main point is that while leaving the eurozone would be painful, it is feasible.

My own view is that this is all too early in the history of the euro to be considering how countries will leave the zone. The euro is only 10 years old, and it is so central to the European ideal that it can be held together for some time yet. The immediate problem for the weaker eurozone economies is not their current account deficits but their fiscal deficits. The current account deficit is financed automatically as part of the functioning of the single currency. But the fiscal deficits are not. They have to sell debt to cover the gap.

So over the next two or three years there will have to be fiscal consolidation in the weaker economies, real wages will have to come down, and those economies will have to become more competitive the hard way. The UK, by contrast, has already become massively more competitive, thanks to the devaluation of sterling, but the scale of the devaluation itself carries risks.

To some extent the fact that the US has a massive fiscal deficit will give political cover for the European countries’ deficits, including that of the UK. It is OK to run a deficit of 10 per cent of GDP because President Obama is doing it. But the new administration seems likely to combine its fiscal boost with increases in taxation that should in theory bring the deficit back to around 3 per cent of GDP, the same level set out in the Maastricht treaty. So Italy, Greece and Spain – and indeed the UK – will only be able to get away with their present projected deficits if they have a convincing plan to tackle them in the medium-term. The markets will force discipline on them.

But as far as the eurozone is concerned, there will also be bureaucratic pressure. The euro, after a shaky start, has become a strong currency because Germany made the sacrifices to ensure that it would be so. It is hard to see Germany letting go that discipline for itself, despite suffering what is at the moment the most serious recession among the large European countries. And if not for itself, why permit it for others?

We will see. The big point here is that just as the recession tested banking structures and they were found wanting, so it is testing the eurozone structure, in particular the “one-size-fits-all” interest rate. And this stress test has only just begun.



Stephen King is away.

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