The new ‘bad equilibrium’ of the euro area

DISCLAIMER: All opinions in this column reflect the views of the author(s), not of EURACTIV Media network.

The euro area has been close to collapse at least three times in the last four years. However the 'strategy of uncertainty,' theorised primarily by the German government and Central Bank to fend off the crisis, is ill-conceived and it is high time to have strategic certainty, writes Carlo Bastasin.

Carlo Bastasin, a journalist and economist, is a visiting senior fellow at the Brookings Institution in Washington, D.C. He has just published a new book titled Saving Europe: How National Politics nearly destroyed the euro

"The euro area has been close to collapse at least three times in the last four years. Nevertheless, the strategy to mend its flaws has never really changed. The idiosyncrasy for the right solutions has to do with the wrong diagnosis.

The eurozone’s crisis is attributed entirely to the limited economic and financial alignment of the weaker member states, which need to trim their fiscal deficits and complete their structural reforms. However, since reforms are triggered by severe pressure from the markets, the uncertainty about the solidity of the euro area that scares governments and makes investors run should not decrease.

That's exactly where we stand with the 'strategy of uncertainty' expressly theorised in Berlin and by the Bundesbank. Pursuing a fiscal programme that is just demanding, rather than being ruthless, have pushed Spanish spreads above the 400 basis points. And since European funds for financial stability (EFSF-ESM), which should eliminate the risk of cataclysms and defaults, have been raised only slightly above the bare minimum, the risk of a contagion has not been fended off. Meanwhile, Italian spreads are quick to follow Spanish ones, despite a budget deficit that this year should shrink to 1.5% of its GDP and a series of reforms that abroad are regularly branded as 'impressive'.

In this friendly environment of fear and uncertainties, not even the extraordinary injection of liquidity by the ECB can do miracles. It has bought governments relative peace, but banks still await assurances before using most of the funds received.

In March, it seemed as if the economy was starting to profit from it – as shown at least by consumer spending in France and new jobs in Germany. However, the recrudescence of financial instability could kill the recovery spurred by the second injection of liquidity by the ECB, which today seems like a mirage.

If we take a closer look at the myriad financial statistics of the ECB, we will have a clearer picture of the problems that continue to penalise the eurozone.

The data of the ECB’s so-called 'statistical warehouse' indicate, for example, that in February 2012, the volume of long-term loans to the biggest companies of the eurozone had returned to the levels of November 2011, prior to the injection of liquidity by the central bank. Not only is the effect of the ECB injection delayed, but the differences between countries continue to remain almost as large as they were in the last months of 2011, when we feared for the demise of the euro.

If we overcome labyrinthitis inside the enormous statistical data warehouse, we will discover that Italian and Spanish companies are paying interest rates on long-term loans from banks that are 3% higher than the ones paid by German companies. Under such disadvantage the required convergence (remember the diagnosis) between weaker and stronger economies could never occur. The opposite is more likely.

One might reply that the interest rate divergence is simply another version of an all-too-familiar figure – the government bond interest rate spread – and that consequently, first, Madrid has to resolve its fiscal problems and soon after the risk premia will decrease also in the private loans. True, but not true at the same time.

The spread is an instrument that forces governments to make the correct political decisions. The differential on the cost of credit to the private sector is instead an obstacle to an adjustment that cannot happen simply by executive order. Rather than being an incentive for growth, the cost of credit can hamper it.

In shaky conditions, such as the one of the eurozone after 2011, the low demand for credit in the countries hardest hit by the recession doesn’t result in lower costs (lower interest rates), but in higher ones. It’s as if we created a private 'bad equilibrium' – in the familiar framework of multiple equilibria indicated by economist Paul de Grauwe – of the kind that, through the costs of public debt, induced last summer’s sovereign debt crisis to spiral.

The 'strategy of uncertainty' is an unorthodox policy instrument. It can work on governments' policies, but it does not have the same effect on private investors’ strategies. Under duress, a government will have to behave and do the right things for its country simply because it cannot decide to move to a different country if it doesn’t like the one in which it has been nominated. But a private investor will move as fast as he can: he is even obliged to do so if his shareholders demand it.

It is certain that the liquidity conundrum will resurface, and the delay with which the ECB’s injection of liquidity affects the economy will not come as a surprise. Normally, the connection between the creation of a monetary base and credit (M3) is fairly predictable, but today’s conditions aren’t normal at all. Banks have little capital and therefore they fear losses.

That same fear grows when they have to lend money outside of their respective countries, and this produces isolation in each state. Risk then increases and credit, similarly, decreases. Four years have passed and the financial crisis still awaits a different answer besides the strategy of uncertainty. It might be the time to attempt a strategy of some certainty."

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