By Desmond Lachman, Resident Fellow, American Enterprise Institute
Judging by the very favorable market reaction to Mario Draghi's announcement in July 2012 that the ECB would do whatever it took to save the euro, one could be forgiven for thinking that the European debt crisis has now finally been resolved. However, European policymakers would be making a grave mistake if they were to allow themselves to be lulled into a false sense of security by the market's relative calm. Since once again the ECB is only addressing the symptoms rather than the underlying causes of the crisis. And it is only a matter of time before Europe's weak underlying economic and political fundamentals again reassert themselves.
Among the main drivers of the European debt crisis over the past two years has been the deepening in the economic recessions across the European periphery. That deepening, which has far exceeded official economic forecasts, has complicated the periphery's task of effecting budget adjustment and of restoring public debt sustainability. It has also compounded European bank loan losses, thereby aggravating domestic credit crunches, and it has provoked a strong political backlash against austerity throughout the periphery.
ECB Hasn't Done Enough
The principal factors contributing to Europe's deepening economic recession has been the severe degree of fiscal austerity that has been required of the periphery by the Fiscal Pact agreed to at the European Summit in December 2011. That pact requires Ireland, Italy, Portugal, and Spain to reduce budget deficits by as much as between 2 and 3 percentage points of GDP a year in both 2012 and 2013. And this budget austerity is being required of these countries despite the fact that these countries are already all in painful economic recessions and despite the meaningful credit crunches that these countries are experiencing.
While the ECB's proposed program of sovereign bond buying has reduced sovereign interest rates in the periphery to more reasonable levels, it does very little to alleviate the strong recessionary forces presently in play in those economies. In particular, it does not reduce the degree of fiscal austerity that will be required of those countries in 2013. Nor does it address the problem of capital inadequacy in the European banks that is causing meaningful credit crunches throughout the periphery. One must expect that the mix of pro-cyclical fiscal and credit policies that countries in the European periphery will continue to pursue next year will lead to a deepening in the European recession in 2013 at a pace not dissimilar to that which occurred in 2012. This would seem to be particularly the case in the context of a slowing global economy.
A deepening in the economic recession in the European periphery will complicate the task of those countries' efforts to restore order to their public finances. It will also increase loan losses at those countries' banks, which in turn will contribute to a further tightening in credit conditions. More disturbing yet, deepening recessions will increase the austerity fatigue that is all too evident across the European periphery and it will heighten social pressures and regional problems in countries like Portugal and Spain.
What About Greece?
In addition to not alleviating recessionary pressures throughout the European periphery, the ECB's new policy initiative does nothing to defuse an increasingly complicated Greek economic and political situation that could very well result in Greece exiting the euro by year-end. Greece's European creditors would very much like to keep Greece in the euro. However, they are insisting that Greece establish some track record of policy performance before a scheduled European Summit on October 18 that is to decide on Greece's next IMF-EU loan disbursement. In particular, Greece's European partners would like to see Greece comply with the conditions of its second IMF-EU financial support program, which requires Greece to secure parliamentary approval of public-spending cuts amounting to as much as 5-1/2 percentage points of GDP for 2013 and 2014.
The painful policy demands being made of Greece, in the midst of Greece's worst economic recession since the 1930s, is exerting a heavy toll on Greece's political stability. The clearest of cracks are now appearing in Greece's newly elected coalition government as the coalition struggles to agree on spending cuts that might meet the IMF-EU's demands. At the same time, labor and social unrest is on the rise, while both political parties of the extreme left and the extreme right are gaining in the opinion polls. These political and social conditions have to raise questions as to the longevity of the present Greek government, whose very survival is closely linked to Greece's chances of remaining in the euro.
Germany Is Not Cooperating
Yet a further challenge for the ECB's efforts to save the euro is the fact that the proposed large-scale purchases of Italian and Spanish sovereign bonds is running into considerable resistance from the German public. While Mrs. Merkel is lending Mr. Draghi considerable political support, the German Bundesbank is openly hostile to the ECB's proposed course of action. In the Bundesbank's view, the ECB's proposed bond buying would be tantamount to the monetary financing of government deficits. One would think that the fear of further antagonizing the public of its main shareholder will force the ECB to desist from any timely easing in monetary policy and to attach the strictest of macroeconomic conditionality to Italian and Spanish bond purchases.
There can be no question that the ECB's recent commitment to save the euro has eliminated the tail risk of any early departure of Italy and Spain from the euro. However, it has done neither very much to alleviate the recessionary forces bedeviling the European periphery nor has it done anything to defuse an increasingly difficult economic and political situation in Greece. As such, European policymakers should expect a further deepening in the European economic recession in 2013 that will only fuel political tensions both in the periphery and in Germany that could once again pose a very real threat to the euro's longer-run survival.
American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.