The eurozone belongs to the category of the simultaneously unbreakable and unsustainable. The two can comfortably sit side by side. But a recession could bring the conflict out in the open.
It is still too early to say whether the observed weakness in the economic data since the second half of last year marks the start of a recession or a mid-cycle dip. I have no views on this point. But when the downturn happens, as it eventually will, the unsustainable will hit the unbreakable.
And then what? There is a lazy answer to this apparent contradiction. When faced with the next crisis, the EU’s leaders will do what they have always done in the past: they will reform. The trouble with this theory is that it is based on a fiction: reform did not happen after the previous eurozone crisis.
If you consider the most probable sources of future tension, the eurozone is no stronger today than it was before it acquired a half-baked banking union and the European Stability Mechanism.
The eurozone only survived during the crisis years between 2010 and 2015 thanks to two decisions, both initiated by Mario Draghi, president of the European Central Bank. The first, in the summer of 2012, was the vague but forceful promise to do “whatever it takes” to prevent the break-up of the European single currency. This was followed up in March 2015 with purchases of eurozone sovereign bonds. But it is worth recalling that quantitative easing was not an overt crisis response. It was only possible because of the eurozone’s descent into disinflation in 2014. Without it, Mr Draghi would otherwise never have found a majority in his governing council for the scale and length of the sovereign bond purchases that ultimately succeeded in stabilising the eurozone bond markets. It was a fortuitous coincidence.
There are three reasons to believe that the ECB is unlikely to act as a backstop in future crises in the same way. The first is that Mr Draghi’s term of office expires at the end of October; there are not many replacement candidates on the horizon with similar instincts. The second is that the ECB can only purchase government bonds within the remit of its policy mandate. Even Mr Draghi’s ECB was never a discretionary actor. And third, the ECB has no room for rate cuts. It says a lot about the eurozone economy that it reached the top of its business cycle with short-term interest rate at -0.4 per cent.
Without an ECB able or willing to do the heavy lifting in the next crisis, real reforms will be needed. Those agreed recently are of the wrong kind. The eurozone does not really need another small structural budget facility. Even if a eurozone budget were to grow to 1 or 2 per cent of gross domestic product eventually — which is beyond what is imaginable by several governments — it would not be enough even to make a dent in a severe financial or economic crisis.
I concluded some time ago that a fiscal union is neither necessary nor sufficient to guarantee the future stability of the eurozone. What it requires instead is a full capital markets union and a single sovereign asset, a eurobond. Benoît Cœuré;, a member of the ECB’s executive board, recently made the point in a discussion organised by the IMF in Lisbon, that a safe asset would also help the EU’s geopolitical ambitions. But the safe asset is the “he who shall not be named” in eurozone policy discussions. It is a political taboo in several member states, Germany among them. Yet without it, no stability and sustainability is conceivable in the long run. Such assets are needed as collateral instruments in financial markets, as replacements for national sovereign bonds in bank portfolios, and as instruments to strengthen the international role of the euro.
Without safe assets, the eurozone will remain prone to crises. Among the foreseeable accidents, an Italian sovereign debt crisis ranks high on the list. Italy’s combination of low productivity growth, high fiscal deficits and a large and growing stock of sovereign debt is unsustainable. The current Italian government may be fiscally more extreme than its predecessors, but successive Italian governments failed to find a sustainable policy mix over a period of 20 years. Another election will not fix the problem.
The obvious solution to Italy’s lack of sustainability in the eurozone would be a debt restructuring. But the eurozone’s governments, its institutions, its banking systems, and its legal systems are not prepared. More likely, instead, is that parallel currencies, unconventional debt securities, or even cryptocurrencies will offer opportunities for an unofficial grey exit. It will turn out that you can be inside and outside the eurozone at the same time. The unbreakable and the unsustainable will find a way to coexist.
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