The threat of contagion in Europe has subsided. More important in securing this relief than the recent Greek rescue deal is the change in European Central Bank (ECB) policy.
The bank's decision to take a more accommodating monetary posture has at last given Eurozone markets and financial institutions the liquidity they previously lacked and desperately need to stop default, or even the fear of default, from spreading. But if the ECB has bought a measure relief, the continued narrow focus of the Eurozone's governments leaves little hope that they will use the breathing space to deal with the array of fundamental problems confronting the union. On the contrary, these underlying problems seem set to linger for years to come.
Europe's leadership has hardly distinguished itself in this crisis. Indeed, it could be said that its lack of conviction and direction has needlessly deepened it. In 2010, when Greece revealed its budget and debt problems, European Union (EU) member nations could have easily disarmed the situation. Greece is a small economy, only 1.9% of the total EU gross domestic product (GDP). Its outstanding debt amounts to a mere 0.8% of the assets of the European financial system. But instead of taking concerted action, Europe's prime ministers, presidents and finance ministers dithered. Each nation, Germany in particular, maneuvered to protect its particular finances. It is little wonder, then, that investors lost confidence in the Eurozone's commitment to its members or even itself.
With confidence lost, it was inevitable that investors would search for risk elsewhere in the union. They found it, first in Ireland and Portugal, and then in Spain and Italy. Even with Ireland and Portugal looking shaky, leadership in the Eurozone could have handled matters. They are also small—respectively only 1.3% and 1.4% of total EU GDP, with comparably small relative debt burdens.
But still, as the crisis spread to them, Europe's stronger members continued to maneuver and worry most about protecting themselves. It was only a matter of time, then, before investor fears turned to the larger, less easily managed members. That happened in summer 2011, when investor concerns turned to Spain and Italy. These economies equal respectively 8.7% and 12.6% of the EU total, with debt burdens of comparable relative size. Their needs, under attack from investors, went beyond the resources of France's or Germany's finance ministries. Matters truly had reached crisis proportions.
Even then, Europe's leaders faltered. Their plans for their preferred rescue device, the European Financial Stability Facility (EFSF), remained ridiculously vague. The Fund, by Europe's own estimates, needed at least €1.0 trillion, and probably more, to meet the needs of the situation. It originally had €440 billion in it, but had already disbursed some €150 billion, leaving a need to lever up the remaining balance almost four times to reach the €1.0 trillion goal.
But the best assurance Europe's leadership could offer was a vague reference to cash-rich nations such as China and Brazil. Though these nations might buy into the fund, as a way to get a general European credit in place of more questionable Greek, Spanish or Italian credits, these countries were never likely to give the Europeans their hoped for €1.0 trillion.
Meanwhile, the maneuvering for position among Europe's member countries continued unabated. The amazing thing in all these negotiations is that throughout Germany and the other so-called strong nations of the Eurozone, they have acted as though somehow they could avoid paying. That desire was clearly evident in 2010, at the start of the crisis, when German Chancellor Angela Merkel played to the German taxpayer, who wanted to avoid spending anything for a Greek or European rescue of any kind, and asked why Germans should have to work so that Greeks can retire at 50. Touching as the complaint was, it was also beside the point. The simple fact is that Germans simply cannot avoid paying. They will either bail out the Greeks and the rest of Europe's weak periphery, or they will have to bail out their banks, which hold much of the debt of these nations. Failing either, Germany and the rest of Europe will suffer a severe recession.
If these brutal facts already leave Merkel over a barrel, the oft-used threat to expel Greece and other nations from the common currency and the EU altogether is fundamentally hollow. It could, of course, be used as a punishment, but still would not get Germany and other stronger nations out from under the obvious financial burdens. In or out of the EU or the Eurozone, Greece, Portugal, Ireland and others would still owe the money in euros and would still be unable to pay it. German and other European banks would remain vulnerable. And expulsion would take away any measure of control. Greece, Ireland or Portugal may choose to leave, but Europe gains little by throwing them out.
But while most of Europe's leadership has ignored reality and made matters worse as a consequence, substantive help has finally arrived from the ECB.
Up until late last year, European monetary policy contributed to, rather than relieved, the continent's financial problems. Claiming that its narrow charter forbade it to intervene on behalf of governments, the ECB left the entire debt matter to the Eurozone's finance ministries. It refused to contribute to any fund designed to relieve default concerns or take any special action to relieve strains on financial markets.
On the contrary, it did just the opposite. While national borrowers scrambled for funds, faced unsupportable financing costs and threatened default, the ECB actually raised benchmark interest rates twice earlier in 2011, for total of 50 basis points. It further curtailed liquidity by restricting the growth of reserves in Europe's banking system, slowing the pace of monetary expansion so that Europe's narrow M1 definition of money grew at a mere 2% to 3% yearly rate—too slow to meet normal economic needs, much less to substitute the liquidity lost in the crisis.
But as the situation became increasingly extreme, even the ECB, it seems, could not face disaster unmoved. When investor concerns spread to Spain and Italy, the bank could no longer kid itself that the zone's governments could deal with the problems. Still hiding behind a facade of reserve, the ECB actually moved quickly. It quieted markets by buying sizable amounts of Spanish and Italian bonds. Then in late 2011, it reversed its previous rate hikes and increased liquidity by reducing bank reserve requirements. At the close of the year, it made available to European banks €489 billion ($640 billion) in three-year low interest loans. Though ECB directors would never use the term "quantitative easing," that is what the loan effectively was. It injected liquidity directly into markets and helped banks recapitalize after the losses of 2010 and 2011.
The ECB will need to do more. Europe's problems demand a special liquidity flow in excess of €1.0 trillion. But the recent policy shift would seem to signal that the central bank is ready at last to do what is necessary, to do for Europe what the Federal Reserve did for American markets and American financial institutions after the 2008-2009 financial crisis.
ECB officials will, of course, continue to avoid interventionist rhetoric. They will refuse to use the words "quantitative easing," even as they embrace its fundamentals. Their new policy path should further relieve the fears of contagion that past leadership failures had exacerbated. The effect is already clear in how Italian and Spanish bonds continued to sell at spreads well short of the extremes touched last summer, even during this latest round of difficult Greek rescue negotiations. The new ECB stand should also offer investors more stable markets in 2012 than they have enjoyed since this crisis began in 2010.
With the ECB buying this important measure of relief, Europe still needs to deal with severe underlying problems. It has to pursue a growth agenda, for instance, to balance what now is an almost exclusive focus on austerity. Still more fundamentally, there is a need to ease the biases built into the euro. But, true to its past ineptitude, Europe's leadership has shown itself incapable of broadening its focus to deal with such matters. That inability was certainly on display during this most recent round of Greek negotiations. All Europe's summit-goers could consider were how to enforce haircuts on the holders of Greek debt and how to enforce fiscal austerity. Until Angela Merkel, Nicholas Sarkozy and other European leaders can expand their focus to deal with the fundamentals, markets and investors will show no confidence beyond that evoked by the ECB.
Far from dealing with difficult fundamentals, Europe's leadership has failed even to agree on the narrow matters with which it seems so wonderfully preoccupied. The summit-goers did agree that private holders of Greek debt would swap their existing holdings for less than half their value in new, longer-term bonds. They also decided that the ECB will not have to write down the value of the Greek bonds it holds. In a vague concession, however, they agreed that the bank would share in any profits it makes on the Greek bonds.
Substantial dispute also remains over whether the International Monetary Fund (IMF) should take a loss. And there is also disagreement on the size of the coupon attached to the new debt. The Germans and the IMF want a low figure, below 3.5%, to ease Greece's financing burden. The private holders want a figure closer to 4%. As a compromise, the agreement offers an elaborate scheme to step up the coupon over time.
On matters of enforced fiscal austerity, confusion also reigns. Germany's Angela Merkel seems to have won rules that would force each country to keep budget deficits below 0.5% of their GDP over the course of an economic cycle, and keep its outstanding debt to 60% of GDP. She also won her point that the EU should impose fines on violators of up to 0.1% of GDP. But sometimes, vague exceptions muddy the rules. French President Sarkozy has insisted that Europe's leadership is in complete agreement, though France's distinct lack of enthusiasm was clearly on display. Meanwhile the United Kingdom and the Czech Republic have refused to endorse any of this plan.
Against this backdrop, it is hardly surprising that Europe's leadership has entirely ignored the more fundamental concern of growth.
The continent does not have the luxury of waiting on this matter either. It stands on the verge of recession, and the deficit control rules set to enforce considerable fiscal restraint will only retard growth further. The declines are already clearly evident in Greece, Ireland and Portugal. Though Italian Prime Minister Mario Monti has mentioned growth, a one-sided emphasis on austerity remains and could produce a vicious cycle in which spending cuts and tax increases so depress growth that deficits expand, demanding still more austerity that, in turn, depresses growth and widens budget shortfalls even further.
Facing such a dire prospect, it would seem only reasonable for Europe—despite the budget austerity—to look for ways to induce growth through tax or labor market reform, for instance, or through a reassessment of their spending and regulatory priorities or even through privatizations. But Europe's summit-goers have said little about such matters and done less.
Nor has Europe's leadership even acknowledged the biases built into the euro. Many have decried the common currency for preventing the kinds of currency devaluations that might otherwise have eased the strains on countries like Greece, Ireland, and Portugal. EU leaders, of course, cannot consider such a route without utterly destroying the euro. But it is unfortunate that they have proceeded as if the euro had no biases. It does. Primary is the distortion caused by the highly divergent rates at which each country joined. Because Germany, for instance, exchanged its national currency for euros at a cheap rate relative to its economic fundamentals, the common currency has enshrined for Germany substantial export price advantages within the Eurozone, especially compared to Europe's periphery. Those nations joined the euro when their national currencies were dear to them compared with their competitive fundamentals. By addressing such biases, Europe could ease the adjustment burden on its periphery. But, as it is, the subject has never even come to light.
There are no easy answers. There never are. Each nation, particularly in Europe's periphery, must deal with the social fallout of its necessary austerity measures, as Greece has shown, and find ways to implement a schedule for budget reform that does not entirely shred the country's social fabric. Each nation must seek out growth incentives that can blunt the ill effects of this austerity, some in regulatory or tax reform, some in the nature of their budget cuts, and some in judicious privatizations.
But Europe can find none of the answers if its leaders fail even to consider the larger, more fundamental issues. As has been so evident so far during this debt crisis, their indecision has been less than useless. It has made the crisis worse. If Europe's leadership continues in this vein, especially now that the ECB has brought relief and bought time, they will steal the last shred of investor confidence in its viability.
Milton Ezrati is the senior economic strategist at Lord Abbett
and affiliate of the Center on Economic Growth in the
Department of Economics at The State University of New York at Buffalo.