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The eurozone is on the brink, but it seems that the ground leading to the precipice is less slippery than a week ago. The core source of concern is no longer Greece, although it continues to be a risk factor, but Spain and Italy.
The diabolic feedback loop involving an economy in recession, a deterioration of bank solvency and an escalation of government debt is a continuous worry to investors. They fear that private debt can quickly become public debt, adding to the possibility of further sovereign defaults.
And they are gravely concerned about the budgetary implications of the double-dip recession that has engulfed several of the peripheral economies and threatens to undermine the entire euro zone.
The most urgent case right now is that of Spain. At the summit just concluded, European leaders reached two very consequential agreements. The first has to do with the direct recapitalization of troubled banks once a European supervisory authority is in place.
This had been a key demand by the Spanish government, which did not wish the recent lifeline of 100 billion euro to compute toward its sovereign debt burden. The second agreement about seniority structure is also of significance given that bond investors were extremely jittery about the terms of the loan to Spain, which was senior to other lenders.
While these European agreements will go a long way to calm the markets, the main problem remains _ the lack of economic growth. The main question mark is whether bank recapitalization will put an end to the credit crunch, which is preventing businesses from investing and households from purchasing durable goods.
If credit fails to flow to the private sector and the state budget cannot be used to prop up demand due to its crushing debt burden, the beleaguered economies of the euro zone may not recover fast enough to reduce unemployment.
In this context, the recent European agreement to spend 130 billion euro on new investment projects is a welcome announcement, although the size of the effort is relatively small. It does, however, signal a shift in the dominant thinking centered on the idea of budgetary austerity.
At its next meeting, the European Central Bank has an opportunity to change its policy stand given the growing signs of recession around Europe. It can and should lower interest rates, and it can and should play a more vigorous role in the market for public debt.
At the European summit, Italy won a key concession regarding the possibility of a bond purchasing program without the strict monitoring mechanisms imposed on Greece. It remains to be seen whether these agreements will be perceived by the markets as evidence of a shift in Europe’s approach to the crisis, one that helps investors overcome their fear that European institutions are not equipped to deal with the magnitude of the problem. The markets have been clamoring for decisive action. Now they seem to be getting bits and pieces of it, which is a good start.
European efforts to create a fiscal union and a banking union are essential to overcoming the crisis in the medium to long run. They do not, however, address the immediate, short-term problems associated with the economic recession, especially unemployment. Distinguishing between what’s important and what’s urgent has never been more crucial. European leaders and the European Central Bank need to understand that the credibility of their long-term policies depends on their ability to address the short-run problems confronting the world’s largest market area.
Mauro F. Guillen is Director of the Lauder Institute at the Wharton School.
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