When European Central Bank President Mario Draghi announced in late July that the ECB would “do whatever it takes” to prevent so-called “re-denomination risk” (the threat that some countries might be forced to give up the euro and reintroduce their own currencies), Spanish and Italian sovereign-bond yields fell immediately. Then, in early September, the ECB’s Council of Governors endorsed Draghi’s vow, further calming markets, the Brookings Institution reported in a research paper.
The tide of crisis, it seemed, had begun to turn, particularly after the German Constitutional Court upheld the European Stability Mechanism, Europe’s bailout fund. Despite the ECB’s imposition of conditionality on beneficiaries of its “potentially unlimited” bond purchases, financial markets across Europe and the United States staged a major rally.
It seems, however, that the euphoria was short-lived. Yields on Spanish and Italian government bonds have been inching up again, and equity investors’ mood is souring. So, what went wrong?
When I welcomed Mario Draghi’s strong statement in August, I argued that the ECB’s new “outright monetary transactions” program needed to be complemented by progress toward a more integrated eurozone, with a fiscal authority, a banking union, and some form of debt mutualization. The OMT program’s success, I argued, presupposed a decisive change in the macroeconomic policy mix throughout the eurozone.
There has been some progress, albeit slow, toward agreement on the institutional architecture of a more integrated eurozone. The necessity of a banking union is now more generally accepted, and there is a move to augment the European budget with funds that could be deployed with policy or project conditionality, in addition to ESM resources. (Germany and its northern European allies, however, insist that this be an alternative to some form of debt mutualization, rather than a complement to it.)
The ESM, supported by the ECB, could become a European version of the International Monetary Fund, and the new funds in the European budget could become, with support from the European Investment Bank, Europe’s World Bank. All of this will take time, but there is some movement in the right direction.
Where there has been virtually no progress at all is in the recalibration of the macroeconomic policy mix. The prevailing strategy in Europe remains simply to force internal devaluation on the southern countries, with excessive austerity aimed at causing severe wage and price deflation. While some internal devaluation is being achieved, it is producing so much economic and social dislocation – and, increasingly, political upheaval – that there is no supply response, despite the accompanying structural reforms.
Indeed, the deflationary spiral, particularly in Greece and Spain, is causing output to contract so rapidly that further spending cuts and tax increases are not reducing budget deficits and public debt relative to GDP. And Europe’s preferred solution – more austerity – is merely causing fiscal targets to recede faster. As a result, markets have again started to measure GDP to include some probability of currency re-denomination, causing debt ratios to look much worse than those based on the certainty of continued euro membership.Read more. (Subscription required.)
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