The euro crisis is not over

This is a slightly extended version of the Perspective column that was first published in today’s edition of Fund Strategy.

Are there signs that the eurozone crisis is on its way to being resolved after almost three years of drama? Many euro-enthusiasts are convinced things are improving but there are good reasons to question this claim.

Three key policy-related developments have recently cheered those who support the eurozone project as well as those who simply yearn for stability: new initiatives from the European Central Bank (ECB), key judgments by the German constitutional court and the results of the Dutch elections. The effect is visible in the recovery of the euro against the dollar since late July.

Back in the early summer the sense of crisis in the eurozone was palpable. The introduction to a report published by the International Monetary Fund in early July illustrates the tone: “The euro area crisis has reached a new and critical stage. Despite major policy actions, financial markets in parts of the region remain under acute stress, raising questions about the viability of the monetary union itself”. Almost three months later there is much more optimism that the region is resilient enough to withstand the challenges it faces.

Things started to look up on 26 July when Mario Draghi, the ECB president, announced that he planned to implement all action necessary to keep the eurozone intact. In early September he followed up on his promise with the advent of what he called “outright monetary transactions” (OMT): purchasing unlimited amounts of sovereign debt.

OMT is meant to be different from quantitative easing (QE) in that the purchases of debt will be sterilised. In other words the money supply will remain constant since bond purchases will be fully offset by withdrawing money from the market.

The plan was approved by all of the ECB’s governing council with the important exception of Jens Weidmann, the president of the Bundesbank. An emailed statement from the German central bank reportedly said that Weidmann “regards such purchases as being tantamount to financing governments by printing banknotes.” Despite this objection the ECB’s actions have played an important role in bolstering the euro in recent weeks.

Another key development was the German constitutional court’s rejection of demands for it to declare unconstitutional the European Stability Mechanism (ESM) and the European Fiscal Compact. This means that both the permanent euro rescue mechanism and the set of rules for governing eurozone fiscal policy can be written into German law. However, the court attached several conditions to its ruling including an insistence that parliament will still have to approve future ESM deals. It also ruled that the €190 billion (£154 billion) limit on Germany’s liability must remain.

The final boost for the euro came from the Dutch election results in mid-September. To the surprise of some the poll was won by pro-euro centrist parties. Support for the eurosceptic Freedom party led by Geert Wilders slumped.

Alongside these moves were indications that policymakers are intend on moving towards a more integrated eurozone. José Manuel Barroso, the president of the European Commission, has proposed not only a banking union for the eurozone but also a plan for “a democratic federation of nation states”. The vision is clearly that the eurozone should no longer be a halfway house to integration with a coordinated monetary policy but many key institutions remaining national. More pan-European institutions are seen as the solution to the challenges the region is facing.

However, it would be a mistake to see this period of relative calm as a sign that the eurozone has resolved its fundamental problems. On the contrary, in many respects they are more entrenched than ever. Arguably the recent initiatives have only made matters worse both in relation to economics and politics.

While Europe’s technocratic leaders devise ever more elaborate pan-European institutions itself the regional economy is in many respects unraveling. Just think about the particularly severe austerity being imposed on peripheral countries such as Greece, Portugal and Spain. This means that the productivity gap between these countries and poor nations such as Germany and the Netherlands is likely to widen further. Yet it was tying such regional economies together in a monetary bloc in the first place that is to blame for many of the region’s problems.

The widening gap is even more apparent in relation to finance. Interest rates on loans available in different eurozone members states are diverging rather than narrowing. This point was highlighted in the IMF’s July report and it is still true today.

Similarly the region’s financial system is becoming more fragmented. Cross-border ties in the region are becoming frayed. As the IMF report said:

“faced by a funding freeze affecting large euro area banks dependent on wholesale funding and contagion of sovereign stress to Italy and Spain, the euro area financial system has fragmented away from an area-wide system to within national borders. This has created de-integrating forces in sovereign bond markets, interbank markets and lending and deposit markets. Sovereign bond and interbank markets have been the most deeply affected by the withdrawals of intra-euro area cross-border capital flows”.

The technocrats’ favoured solution to such problems is always more integration. But in some respects the economy is moving stubbornly in the opposite direction to the one they desire. This is because, whether the technocrats like it or not, the eurozone still remains a set of highly divergent economies.

Even worse the drive to create a regional economy without winning a popular mandate first is highly undemocratic. None of the initiatives above are a response to popular pressure. On the contrary, whenever possible the move towards greater integration studiously avoids subjecting itself to democratic approval. The eurozone’s leaders may talk of “democracy” but they clearly do not mean it in its proper sense of rule by the people.

Although they typically avoid saying it openly the eurozone’s technocratic elite seems to have a disdainful attitude towards the public’s ability to understand what is going on. Perhaps if instead Europe’s leaders had submitted their initiatives to a democratic mandate the region’s economy would not be in such mess.