By EDWARD P. JOSEPH and ANGELO FEDERICO ARCELLI
Published February 6, 2013
Is the tide finally turning on the European financial crisis? According to conventional wisdom, the answer is yes. Citing recent reforms and a new bailout for Greece, there is growing optimism about Europe’s financial prospects. Unfortunately, the belief that Europe has turned the corner on crisis is premature — and dangerous. Little has been done to correct the fundamental flaws that spawned Europe’s ill-fated common currency, the Euro. Premature optimism relieves Europe’s ever cautious policy makers from taking the bold steps needed to truly stem the crisis.
To grasp how far Europe still has to go, think about how the Euro was launched. Driven largely by political considerations, the architecture for the currency turned out to be as imaginary as the fictional bridges and buildings that decorate the paper bills. There is no treasury behind the Euro. The founding charter of the European Central Bank (ECB) gives it limited powers, far weaker than those of the U.S. Federal Reserve. In theory, Brussels has the tools to act as a common controller for the Union — but in reality, its Commission lacks the enforcement powers to be effective.
Instead of providing the superstructure undergirding every other currency in the world, the Euro’s visionaries believed that over time the economies that used the common currency would ‘converge.’ Bankers and markets also invested in the illusion, and the bonds of profligate Eurozone states, like Greece, traded at nearly the same spreads as those of Germany or the Netherlands. The illusion blew up in the wake of the U.S. financial crisis, which popped the Trans-Atlantic liquidity bubble.
Instead of forthrightly confronting the flaws, Europe’s response was — and remains — largely a collection of uncoordinated half-measures. When the banking system came under pressure, with few exceptions, the vaunted ‘Union’ rapidly descended into individual actions by each country aimed at saving ‘national’banks. Markets soon grasped that when it came to risk there was, in fact, no ‘Eurozone’ at all, but, rather, a highly variegated conglomeration of EU countries sharing a single currency without the infrastructure to sustain it.
And instead of convergence, a dangerous rift opened between indebted Eurozone countries that saw borrowing costs soar, and the mostly Northern members who continue to enjoy favorable credit ratings. Sackled to a common currency, the troubled countries cannot devalue their currency — remaining at competitive disadvantage as they struggle to implement reforms.
The steps taken to address the most urgent case — Greece — have been both inadequate (due to overly optimistic scenarios about the Greek economy) and draconian (due mostly to wide-spread German skepticism about the commitment in Athens to real reform). It is true that following more austerity and a major bailout concluded in December, Greece’s credit rating has come up a notch. However, the real economy in Greece — on which its ability to remain within the Eurozone ultimately rests — has seen little improvement. Even with the latest bailout, there are still fears that Greece may yet sooner or later collapse under the weight of its staggering debt burden.
The really frightening scenarios concern the far larger Spanish and Italian economies. European leaders and the IMF are assembling a safety net for Spain, but doing the same for Italy — whose economy is deeply intertwined with that of Spain — is impossible. Italy is simply too big to fail — or to bail out.
Optimists cite other steps like the the EU’s decision to create common banking supervision. While this may prevent the next crisis, it has come too late in the game for the current one. Banks still suffer from heavy exposure due to irresponsible lending in the past. Likewise, the ECB’s governing board created an innovative new mechanism for the Bank to buy up the debt of troubled economies. In truth, none of the reforms come close to rectifying the inherent structural problems of the Euro.
Indeed, along with the illusion of an unstoppable convergence process, another casualty of the crisis was the widely-held assumption that a common currency would, ipso facto, herald political and even fiscal union. Without a strong mechanism to police the spending of Eurozone members, Berlin is unwilling to continue anteing up for successive crises.
In the end, rosy optimism is as pernicious as gloomy pessimism. It releases the pressure on European leaders to make politically charged decisions. Without a sense of urgency, truly essential — and exceedingly difficult — reforms will not be achieved. The correct posture is neither despair nor optimism, but rather vigilance. Washington should seize every opportunity to remind EU leaders that temporizing will not bring Europe out of crisis. The time has come to tackle the Euro’s inherently inadequate architecture.