Thoughts on the Euro's Outlook in 2013
Despite the numerous predictions of its demise, the euro is alive and well at the end of 2012. Indeed, it has again held its value against other currencies during the year,1 confounding skeptics just as it did a year ago. As 2012 comes to a close and the last European Union Council of the year has ended—there have been seven in 2012!—it is time to take stock. As someone who ended 2011 on a positive note for the euro, I am happy to report that the outlook remains positive for 2013.
Pessimism will never go out of style, of course. The next year will no doubt be littered with more predictions of gloom from commentators with limited appreciation of the core political nature of the euro area crisis, or with incentives to predict the worst. The business model of certain euro "tail-end risk merchants" seems always to predict disaster 18 months ahead to secure maximum media interest in their op-eds, and revenues from their conference speaking fees and consulting businesses. Some European commentators make a living out of selling "political intelligence" to English-speaking financial market participants. For these characters, the worse the euro area crisis is, and the more obstinate Chancellor Angela Merkel and Germany appear to be, the better business will be.
In the United States, liberal commentators like Paul Krugman have an equally perverse incentive to declare that austerity has failed in Europe. Their perhaps laudable motive is to help the political case against the GOP's (disastrous) fiscal plans in Washington. Rarely, however, does this group consider the wasteful consequences of reflating structurally unreformed euro area economies. What they do not understand is that unlike the United States, the euro area core and periphery suffer from more than a "demand problem." Yet at least Krugman and other liberals are intellectually consistent when criticizing euro area austerity. Various US and British conservative commentators have no such cognitive concerns. They happily condemn euro area Depression-era policies, while praising the similar fiscal policies of their own GOP and Chancellor of the Exchequer George Osborne in the same breath.2
The euro area doom stories in 2013 will likely revolve around the "Grexit/Spaxit/Portxit/Finxit/Brixit" form. That is, English-speaking market economists in the City of London or on Wall Street will pontificate about the euro area breakup or the rush by Greece, Spain, Portugal, Finland, and Britain to return to their national currencies. These predictions rest on the dubious assumption that the 1930s are here again, and that economically distressed euro area populations correspondingly can again be expected to make rash and dangerous political choices. But in all euro area elections in 2012 in which incumbents were booted out, centrist and pro-euro governments replaced them. The simplistic and economically deterministic belief that populist anti-euro governments will be voted into office ignores decades of successful consensus building by the European elite, and the risk averse nature of an aging and still prosperous European electorate. Most voters will not take a chance on a new drachma, lira, or escudos. Market participants betting on the opposite will continue to lose money in 2013. Unjustified disaster scenarios can still be valuable, on the other hand, if they add pressure—in a non-threatening manner—on EU policymakers to do the right thing.
What were the most important developments in December 2012 and what do they tell us about 2013?
For Greece, 2013 Will Be a Year of Muddling Through
The Greek government, the euro area, and the International Monetary Fund (IMF) agreed in December to undertake new steps to keep the country from economic collapse. IMF managing director Christine Lagarde was at pains to emphasize that these measures will "ensure that Greece's debt-to-GDP declines to 124 percent by 2020 and to substantially below 110 percent by 2022." Yet the many failed predictions of the recent past suggest that it is meaningless to predict the Greek economy 10 years into the future. The fight between the euro area and the IMF over a few percentage points of the debt-to-GDP ratio ten years from now was Kabuki theater aimed at demonstrating the Fund's (and Ms. Lagarde's) political independence. But as discussed earlier on RealTime, none of the major shareholders in the IMF wants to pull the plug on Greece. The euro area, for its part, needs to keep the IMF on board to pay a third of the bill and provide invaluable technical expertise and market credibility.
Some might question the financial wisdom of the Greek debt buyback, which was part of the recent euro area-IMF deal. It is quite likely that investors "front-ran" the buyback option, figuring that higher bond prices removed any financial benefit for Greece. However, such narrow financial considerations miss the broader political function of the debt buyback, which serves as a tool with which the euro area kept the IMF happy and engaged in Greece. As Bulow and Rogoff noted in their critical 1988 paper on debt buybacks,3 "[s]uch programs might be valuable as components of efficiency-enhancing larger deals between debtors and creditor." That was what happened in this case!
More important for the future, the fact that the IMF remains on board financially and politically, and the euro area's decision to release €49 billion in financial aid for Greece (amounting to 25 percent of its GDP) contradicts the belief in a Greek exit. Eventually even Citibank and its Grexit-predicting peers will see the light.
Leaders in Berlin, Brussels, and Paris decided in 2012 to keep Greece in the euro area, knowing that a Greek economic and political collapse following the country's exit would undermine the euro area members' quest for more integration to complete the common currency's institutional design. They understood that a failed state on the borders of Europe would impede the effort to construct new institutions and persuade European electorates to support a new EU Treaty. EU institutions cannot be expanded while Greece burns.
From the perspective of Athens, where would the 25 percent of GDP in urgently needed aid come from, if not from the euro area? The €49 billion being disbursed amounts to more than 35 times Greece's IMF quota of about €1.3 billion. The Greek coalition government that will stay together in 2013 will also do what is required to keep the euro area and IMF satisfied and the financial assistance flowing. Neither the Socialists (PASOK) nor the Democratic Left will call for a new election in 2013, when the economy will still likely be contracting. To do so would invite annihilation at the hands of the populist Syriza party.
For Europe, a Step Toward Banking Sector Integration
In December the European leaders also agreed on the first component of their banking union by launching the Single Supervisory Mechanism (SSM) to integrate euro area banking supervisors with the European Central Bank (ECB) at the center. [pdf] As my colleague Nicolas Véron writes, this is a first step on a long and winding road towards banking sector integration in Europe, but nonetheless a very big one. Plenty of people doubted that European leaders could reach agreement in just six months on such a monumental task. Even though implementation is not likely until March 2014 (21 months after initiation at the June 2012 EU Council), the pace is impressive. Recall, for example, that neither Dodd-Frank in the United States nor the transfer of the Financial Services Authority to the Bank of England is yet to be fully implemented, two and a half years after they were passed by Congress and the UK Parliament.
EU leaders have further directed the EU Commission to complete a Recovery and Resolution Directive and a Deposit Guarantee Scheme Directive before June 2013. The commission also has proposed a single resolution mechanism (SRM) for member states participating in the SSM for adoption before June 2014. These steps will be complex and politically challenging for the EU Commission and EU finance ministers. The process involves both a lot of money (who pays if a bank fails?) and a great deal of national sovereignty (who decides if a bank must be liquidated or bailed out?). But EU leaders have committed themselves to a rapid decision-making timetable, just as they did on banking supervision. The ECB president, Mario Draghi—whose powers of political persuasion are not to be underestimated—has declared the SRM to be a vital complement to the SSM. The rapid timeline outlined by EU leaders is thus realistic.
The agreement on the SSM, moreover, makes other strategic concerns for the European Union less pressing. The SSM is intended to equip the euro area with the institutions needed to keep its currency viable. One question facing a single supervisory mechanism relates to the possibility of additional euro area-only integration without driving non-euro members out. This is obviously mostly an issue with respect to the United Kingdom, the only non-euro member of the European Union unlikely to join the common currency in the foreseeable future. The United Kingdom, after all, is home to what will likely remain Europe's premier financial center in London. Here one cannot underestimate the importance of the agreement among all 27 EU members to launch the SSM, while letting some members (such as the United Kingdom, Sweden, and the Czech Republic) remain on the outside—and still set banking rules for all 27 member states through the European Banking Authority. The Conservative UK government's acceptance of this new European institutional setup for arguably Britain's most important economic sector (banking/financial services) effectively ends the risk of the United Kingdom sleepwalking out of the European Union. Of course, many pro-exit Tory Members of Parliament will still press for an in-or-out referendum on British membership or at least repatriation of EU powers back from Brussels to London. Thus the high pitch euro-skeptic noise in London will continue, as the single-issue anti-European Union United King Independence Party (UKIP) tries to become a viable electoral alternative in British politics.
The emergence of a politically acceptable solution accommodating euro area banking integration and the City of London's insistence on independence takes critical wind out of the sails of proponents of a UK EU exit. Prime Minister David Cameron would never say it,4 but such a workable solution lessens the likelihood of a parliamentary or public majority demanding that Britain leave. Both the Labour Party and the Liberal Democrats would ultimately support British EU membership, as would the vast majority of British industry and—now critically important—also the financial services industry. Hence a sufficiently large chunk of the Conservative Party would also likely favor continued EU membership, ensuring that a pro-EU majority in Britain. That is good news both for Britain and the European Union.
Europe Also Moves Slowly Toward Fiscal Policy Integration
EU leaders have taken modest steps to further fiscal policy integration in the euro area. Both the European Commission Blueprint [pdf] and the report by EU Council President Herman van Rompuy [pdf] have envisioned an expansion of the euro area's fiscal capacity. But EU leaders essentially put these on hold for the next six months. The President and the EU Commission were merely directed to present new possible fiscal measures [pdf] concerning mutually agreed contracts for competitiveness and growth by June. These would include "solidarity mechanisms that can enhance the efforts made by the Member States that enter into such contractual arrangements for competitiveness and growth." This is a very modest fiscal policy integration agenda. It does not even mention the establishment of a new euro area fiscal capacity to counteract an asymmetric shock. The EU leaders seem not to have heeded the lessons of the crisis or listened to their own top advisors—the four EU presidents—on this issue.
It might seem predictable for talks about expanding the euro area budget to be postponed until the issues surrounding the EU budget are settled (probably in the early Spring 2013). But the basic political reason for this disappointing outcome is straightforward. Chancellor Merkel does not want to go further at this point. She thus simply said "No." Her intransigence derives from the German election campaign, where she has very successfully—judging from her sky high approval ratings in Germany—adopted a political strategy essentially emulating the IMF. German financial assistance will be forthcoming only as a quid pro quo for reforms and austerity in the recipient countries. At this point, German financial "solidarity" demands that fiscal integration and assistance for troubled countries be made contingent on their commitments to reform. Broader open-ended fiscal integration remains at present unacceptable to Germany.
This tradeoff seems unlikely to change until EU Treaties are revised to include more political integration in the form of new joint political institutions. Such a goal cannot be reached until other euro area members, especially France, come to grips with how much additional political sovereignty they are willing to cede. The age-old debate between Germany and France about political vs. financial integration in Europe, and the timing of each, thus continues. Germany, however, is the quintessential veto player in Europe. Accordingly, progress cannot come until France (and other nations) show more willingness to pool political sovereignty. As long as Germany writes the checks in Europe, Berlin will decide the tempo of integration.
The major changes to the EU Treaty demanded by Germany and others would require a new full ratification period and several referenda. There should be no surprise about this. Fiscal policy involves tough political resolution of the basic redistributive choices of a society. Unlike the issues related to the technocratic and complex aspects banking regulation, fiscal issues cannot be hidden from voters. In the current depressed conditions of Europe, it would be hard enough for EU political leaders to agree on a new EU Treaty, let alone get popular support in the process. Postponing this debate until better economic times is hardly a surprising political choice. Little progress on fiscal integration in the euro area is thus in the offing in 2013.
Other Political Economy Predictions for 2013
Ireland will get a new deal on refinancing its National Asset Management Agency (NAMA) promissory notes next year, enabling it to exit its IMF program. A deal seems likely in the spring, providing Merkel with a euro area "success story" based on austerity and reforms in time for the German elections.
Spain continues to look marginally more likely than not to ask for a European Stability Mechanism/European Central Bank (ESM/ECB) program in early 2013. This will probably not happen until after the Cypriot IMF program has been completed and approved by several euro area national parliaments. Somewhat to the surprise for yours truly, the Spanish government may decide that the current still relatively high costs of capital for the Spanish sovereign and private sector are acceptable to avoid the political risks of an approach to the ESM/ECB. The fear in Madrid will be that they will not see a noticeable further reduction in sovereign and private cost of capital after applying for euro area financial aid. The ECB, for example, will not intervene proactively to lower their cost of capital further. Spanish leaders do not want to be open to the political charge of dancing to Germany's tune without getting anything in return.
For Spain, 2013 will also be the year in which the recent drive for Catalan independence dies. The pro-independence vote may have increased in recent regional elections, but Catalan president Artur Mas and his CiU party suffered a large defeat, robbing the movement of a required undisputed political champion. Without a strong personal electoral mandate, Mas faces a fight to keep a burly left-right regional governing coalition together in the face of fiscal austerity. It may make political sense for him to continue to press for a Catalan referendum on independence in 2013, but the central government will ultimately block such a vote. In such a scenario, Mas achieves political martyrdom in the eyes of Catalans, but there are advantages also for Prime Minister Mariano Rajoy, who would enhance his own standing as the defender of Spain's territorial integrity. So while both may have an interest in continuing a controlled political confrontation in 2013, it will be little but political theater.
As for Italy, talk of a return by former Prime Minister Silvio Berlusconi will fortunately be a short-lived affair. Whether Prime Minister Mario Monti—who resigned earlier this month—ultimately runs for office, the key parameter to watch is the combined share of the populist vote—namely the Northern League, the Five Star Movement and Berlusconi's rump party. Monti's early resignation is pushing Berlusconi into the populist camp, as the more mainstream parts of his earlier center-right grouping split away. In line with earlier euro area elections—and despite the disarray of Italy's center-right and low credibility of the country's political class in general—I believe the three populist movements in Italy will have to fight over about 30 percent of the total vote. The majority will likely stay with the center-left (e.g., Pier Luigi Bersani) and the center/center-right (e.g., people like Pier Ferdinando Casani, Gianfranco Fini, Luca Cordero di Montezemolo and perhaps Monti). I regard the political risk of the Italian elections as small. Populism will not gain a majority. If there is a hung parliament without a majority behind a specific government (likely led by Bersani), there will still be a majority lining up behind a potential new technocratic prime minister.
The German election in September will essentially be a non-event. The current "Grand Coalition" between the Christian Democrats and the Christian Social Union (CDU/CSU) and the Social Democrats (SPD)/Green Party on major euro area issues will continue no matter what the election outcome is. Merkel's high personal approval ratings will likely remain even if there is a short-lived and shallow economic slowdown in Germany in Q4 2012. Despite that, the CDU seems certain to become the largest party at the election. Merkel is thus most likely to continue as Chancellor, but she may have to find a new coalition partner, should the Free Democratic Party (FDP) not make it into the Bundestag.
In the end, though, strategic balloting by center-right voters (e.g., shifting from CDU/CSU to the FDP) might push the FDP above the 5 percent threshold. Alternatively, Merkel can repeat the 2005–09 Grand Coalition, or try entering into government with the Green Party. The latter would be a major new step in German politics, but it has been made possible by Merkel's endorsement of the nuclear phaseout and the stronger standing of the centrist "realos" inside the Green party recently. The final possibility is that Merkel's election victory will be too small, and the SPD/Green party instead gets a majority. But as mentioned, this change in government will not make any material difference in Germany's euro area policies.
1. The ECB and Bank for International Settlements (BIS) real and nominal effective exchange rate indices for the euro are essentially flat for the year.
3. Bulow, Jeremy and Kenneth Rogoff. 1988. The Buyback Boondoggle. Brookings Papers on Economic Activity, 2: 675–704.
4. The fact that David Cameron agreed to join the SSM, after having blocked making the Fiscal Compact Treaty part of EU law, further illustrates how the decision among the 26 other EU members states not to be blocked by Britain probably has had the political effect to generally make the limits of London's veto power in the EU clear to the British government and hence increase the political benefits of being at the table.