Let Us Welcome the Eurozone's "New Normal"

September 10, 2010 10:00 AM

In recent days the eurozone has reentered the headlines (in USA Today, the Financial Times, and the Wall Street Journal among others) amid fears of another round in the continent's sovereign debt crisis and rising peripheral bond spreads. Yet contrary to the tone of some commentary, this is excellent news. It should be welcomed by anyone interested in the long-term economic health of the eurozone. It means also that financial markets are finally policing the economic policies of troubled eurozone members and punishing the laggards in real time.

This is the "new normal" in the eurozone of diversified government bond yields and rapidly applied sovereign default premiums and represents Europe's best chance to achieve its required structural economic reform agenda. In 1999, eurozone policymakers surrendered the option of devaluing individual currencies, turning monetary policy over to the European Central Bank (ECB). Since the spring of 2010, they have lost the option of unsustainable fiscal policies in the face of the judgment of markets. They are thus left with the only remaining option—implementing tough supply side reforms. Paraphrasing Winston Churchill's famous comment about the United States, eurozone leaders will "do the right thing"—once all the other options are exhausted.

It is consequently very encouraging to see that financial markets are now rewarding reform progress in Spain (and to a lesser extent in Italy, although Italy without a housing bubble and with a high domestic savings rate was never really one of the eurozone crisis countries). The markets are also punishing the lack of reform progress in Ireland and Portugal, while continuing to believe that some kind of restructuring (within the eurozone) is the most likely ultimate outcome for Greece. This is illustrated in figure 1, which shows long-term bond yields for eurozone safe haven Germany, Italy, Spain, Portugal, Ireland, and Greece.

The picture in figure 1 is clear—German safe haven bond prices go up, while Italy and Spain are unchanged and can be seen as clearly distinct from the three small peripheral eurozone members—Portugal, Ireland, and Greece. Evidently, the real economic concerns are at this moment concentrated in only these three small members. And this is no coincidence; Ireland clearly continues to be punished for the unconvincing handling of the Irish bank disaster, while Portugal is singled out because the country's structural reform progress and new austerity measures implemented since mid-May 2010 are insufficient. (In neighboring Spain, by contrast, parliament has approved tough new austerity measures; a labor market reform and plans for pension reform have been announced). Meanwhile, as mentioned before, investors continue to believe that restructuring is ever more probable for Greece.

Since the beginning of the global credit crisis, it has been common for economists to use the unflattering term "PIGS" or "PIIGS" to describe the difficulties of Portugal, Italy, Ireland, Greece, and Spain. The time has nearly come, however, to drop the plural and go for the singular form in discussing the "PIG" countries. Spain and Italy are simply at present not part of this group. Of course the situation could reverse again, especially if the government of Prime Minister José Luis Rodríguez Zapatero fails to pass its new budget or fails to achieve meaningful pension reform (e.g., a minimum retirement age increase to 67), or if Italy also stumbles on the way to new labor market reform initiatives.

The fact that the acute eurozone problems seem, at the moment, concentrated in the small peripheral economies, and far less so in the larger Mediterranean members, is good news for the eurozone in general. And if this pattern is sustained—i.e., that a line in the economic sand is drawn between the three small peripherals and Spain and Italy—it would very substantially decrease the broader economic "spillovers and contagion" to the rest of the eurozone from an ultimate default of any of these three small members. Simply put, none of them are too big to really matter for the survival of the eurozone.

Moreover, a "Greek solution" to deal in the short term with a sudden emergency in any of the three small peripheral countries can likely (with an anticipated 50 percent contribution from the International Monetary Fund) be financed via the €60+35 billion lifeline provided by the IMF and the European Financial Stability Mechanism (EFSM) operated through the European Commission budget and guaranteed by all the 27 members states. As the first line of defense, relying on the EFSM in future "small state emergencies" may mean that the larger and more controversial €440 billion European Financial Stability Facility (EFSF) may not be needed. This would reduce any "implementation risk" associated with any potential "Greek style bailouts" of other small member states.

Lastly, recent trends in eurozone government bond spreads illustrate the futility of attempts by American commentators—Paul Krugman is the most noticeable—to rely on cherry-picked outcomes from the eurozone bond markets to score political points in the debate over austerity versus stimulus in the United States. Comparing Spain and Ireland—two countries sharing a common currency with 14 neighbors, of which only one (Ireland) has suffered a full-blown double real estate and banking crisis—and drawing conclusions about the dangers of austerity in the United States (a large country with its own currency)—is akin to comparing apples to oranges in order to get insights about watermelons.