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Berenberg Macro Views Economics Confusing dreams and reality “Sleepwalking into the abyss” or “the euro crisis is back”. For the last six months, British media including The Economist have missed no opportunity to predict imminent disaster for the Eurozone. So far, however, the crisis monster has failed to rear its head again. With a gradual fading of market tensions, the Eurozone economy has started to recover. How come? In analysing the euro crisis, many observers make a simple mistake: they conflate their dreams for a perfect world with reality. The world does not have to be perfect in order to work. For example, Germany would arguably be much better off if it had a simple flat tax and a deregulated labour market. But in real life, a ridiculously complex tax system and an overregulated labour market have not prevented Germany from turning itself into the economic powerhouse of Europe. In the same vein, most Britons would live a more comfortable life if the country had a properly functioning housing market. But in real life, Britain’s absurd restrictions on the supply of new houses are not preventing the country from enjoying a credit-fuelled economic upturn. The same logic holds for the euro crisis. Many observers believe that the region needs full political union, full fiscal union, an immediate banking union and a full German/ECB guarantee for sovereign debt or the realisation of some other pipedream to get out of its crisis. Some of the arguments such observers make are not wrong. Yes, some kinds of financial tensions could be contained more reliably by a full-scale mutualisation of public debt or other variants of fiscal or even political union. And yes, an immediate banking union or any other way to end the credit crunch for small and medium-sized enterprises in parts of the euro periphery in one fell swoop might be quite helpful. But discussing what may or may not be desirable is very different from analysing what is strictly necessary for the euro crisis to fade. Sleepwalking into the abyss? Not really You don’t have to be perfect to get some growth Desirable does not equal essential The bare essentials Stripping it down to the bare essentials, the Eurozone needs four ingredients for its crisis to fade. All four are in place. 1. A reliable mechanism to contain contagion: The problems of small countries must not endanger the region as a whole. Since Draghi’s announcement on 26 July 2012 that the second most powerful economic institution in the world, the European Central Bank, would not commit suicide but would instead do all it takes to preserve the euro and its own existence, this ingredient is present. 2. The right incentives so that countries like Greece fix their underlying problems. With the tough-love approach pursued by Germany and the ECB, this ingredient is there as well: Europe helps nations such as Greece or Ireland with serious amounts of money if the recipients submit to harsh reform conditions. 1 Despite occasional hiccups, the reform process is well entrenched and well advanced. 2 Contagion control in place Crisis countries are adjusting 1 We explain this approach in detail in Tough Love: the true nature of the euro crisis, Berenberg, 20 August 2012. 2 See for example our Euro Plus Monitor, Spring 2013 Update, Berenberg and Lisbon Council, 7 March 2013. 2
Berenberg Macro Views Economics 3. The political will to stick to the grand bargain: The strong help the weak while the weak accept the strings attached. All German mainstream political parties back Chancellor Merkel’s euro policies. No realistic result of the German election on 22 September 2013 could lead to Germany turning its back on its European partners. 3 At the periphery, the will to do what it takes to stay part of the euro family has survived numerous challenges including elections and changes in government in Greece, Ireland, Portugal, Italy and Spain. 4. Some growth in key export markets: To export their way out of their domestic adjustment recessions, the euro peripheral countries need some increase in global demand and in core European domestic demand. So far, external demand has proved suitably resilient. For the euro periphery, good news from Germany, the US, UK, China and Switzerland is more than offsetting the wobbles in a number of emerging markets. Of course, past performance provides no guarantees for the future. But it does hold lessons. Eurosceptics and the readers of those British media who know very little about what is really happening on the continent underestimate at their own peril the capacity of the Eurozone to contain and overcome its crisis. The political will has survived various elections Key export markets are growing Risks are receding as economies turn the corner Serious risks remain, including the risks that (i) the German Constitutional Court could constrain the ECB’s OMT safety in a way that renders it ineffective or that (ii) potential new elections in Italy or Greece could sweep irresponsible mavericks like Beppe Grillo or Alexis Tsipras into power. But with the peripheral economies starting to stabilise and the rise in unemployment starting to fizzle out, the vulnerability of the Eurozone to contagion hazards and the political challenges in peripheral economies are now less serious than they used to be. It could still go wrong. But it would now take a bigger shock to trigger massive new tensions. Also, the probability that such a shock will occur has receded. In the next two sections, we take a closer look at the two major risks – the German Constitutional Court and Italian politics. Of course. Life is full of risks It would no take a bigger shock to trigger a new wave of crisis Risk 1: Italian politics In early 2013, Italian politics topped our list of what could still go wrong in the Eurozone. The risk receded when Italy’s President Napolitano (our favourite excommunist) forced Italy’s centre-left and centre-right into an uneasy coalition in early April after the inconclusive election of late February. The risk could flare up again if the centre-left votes to strip the centre-right leader, the convicted tax fraudster Berlusconi, of his Senate seat and the centre-right then withdraws from government. The Senate is scheduled to vote on 9 September, although the vote might still be delayed. New Italian elections would create new uncertainty. That would be awkward. But as we argued in March, the later such new elections come, the less disruptive they would Thank you, Mr President Less concerned than 3 See our German election preview: the other lady, Berenberg, 27 August 2013. 3
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