By Desmond Lachman
When the history of the euro crisis is written, markets will not come out well. For after having completely failed to anticipate the crisis in the first instance, markets now seem to be overly complaisant at a time that the clearest of political ill-winds of change are blowing through the Old Continent. And by being overly complaisant, markets are failing to fulfill their role of imposing discipline and pressure for economic and political reform on wayward European politicians.
By now it is increasingly recognized that the recipe of severe budget austerity and structural reform that has been imposed by Europe’s core countries on Greece, Italy, Portugal, and Spain is not working. Indeed, there is a growing recognition that the application of severe budget austerity within a euro straitjacket is driving the European periphery’s economy into a downward economic spiral. Even the IMF now owns up to the fact that the adverse impact of budget belt tightening on economic growth has turned out to be very much more severe than it had originally anticipated.
Any doubt that budget austerity is not working in Europe must be allayed by the consistent tendency for the economic downturn in the European periphery to have been very much worse than officially projected. Despite repeated official reassurances that the Greek economy would soon bottom out, the Greek economy has now entered its sixth year of recession. And notwithstanding a more than 20 percent decline in Greek output to date, a further 4 ½ percent GDP decline is officially predicted for 2013.
For their parts, the Italian, Portuguese and Spanish economies have now declined for around eight consecutive quarters and they are officially each projected to decline by a further 1 ½ to 2 ¼ percent in 2013. As a result, by end-2013, or five years after the Great Economic Recession ended, these economies’ output will be almost 10 percent below its 2008 peak. Meanwhile the Spanish unemployment rate has already risen to a staggering 26 percent of its labor force.
While markets seem to have internalized the damaging impact of budget austerity on economic performance, they do not seem to be focused on the adverse political fallout from ever rising unemployment levels in the European periphery. Nor do markets seem to be paying much heed as to how deteriorating political conditions in the European periphery are sapping political support for continued budget austerity and as to how they are undermining consumer and investor confidence.
Italy provides the clearest and perhaps most disturbing indication of the market’s indifference to Europe’s deteriorating political circumstances. For despite an Italian election result on February 25 that could hardly have been worse, where 60 percent of the electorate voted for parties skeptical about Italy’s continued euro membership, Italian long-term bond yields barely increased and are now back to their pre-election levels. And by failing to react, markets are not exerting the pressure that they should be exerting to force the Italian political class to restore some semblance of governability in that country. Instead Italy is being allowed by the markets to take its sweet time in exiting from a political stalemate where three political parties have divided the vote fairly evenly amongst themselves.
The market’s indifference to recent Italian developments is all the more surprising given that Italy already has a public debt to GDP ratio of close to 130 percent and a public debt level that is close to EUR 2 trillion. It is also surprising given the toll that a prolonged period of political instability must be expected to exact on the Italian economy as well as given the fact that the ECB can no longer backstop the Italian economy by large scale Italian government bond purchases in the secondary market. As long as Italy does not have an effective government, Italy will not be in a position to negotiate an IMF-EU type adjustment program that is a necessary condition for such ECB bond purchases.
While the deterioration in the Italian political environment in response to a weakening economy is perhaps the most troubling given the very large size of that country’s government bond market, it is hardly the exception. In Greece, opinion polls show that Syriza, the extreme left wing political party that demands a renegotiation of the country’s IMF adjustment program, now enjoys a majority of the Greek vote, while in Cyprus opinion polls indicate that 67 percent of the electorate thinks that Cyprus should leave the euro. Meanwhile in France, Portugal, and Spain, political opposition against austerity seems to mount on a daily basis, while in Germany a new political party, whose main plank is opposition to Germany’s continued membership in the euro, has entered upon the German political scene.
Sadly, there is every prospect that the European economy will continue to weaken in the year ahead as it soldiers on with fiscal austerity within a euro straitjacket. This must be expected to further poison the European political environment. It must also be expected to raise questions about where all the bond vigilantes might have gone.
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.