The start of a new year is a time of resolve. This certainly appears to be the case with respect to European Union President Barrasso, who last week boldly — some might say rashly —predicted that 2014 would be the year of European renaissance.
I hope he is right; I fear he may be disappointed.
To be sure, there have been very encouraging developments in euroland. Ireland, for example, has exited its troika-led support program and has regained access to private capital markets. And, across the euro zone more broadly, spreads between periphery members' interest rates and the German core of the union have narrowed considerably from the dizzying levels of two years ago.
The question is whether the narrowing of spreads will continue without interruption. Such an outcome is certainly possible. But it would, I think, require a remarkably quiescent global environment. That may be the case, but then again... the key question is: how stable is the decline in periphery interest rates that we have seen?
Two factors are of critical importance in understanding the improvement in European financial markets over the past 18 months. The first is the announcement made by ECB president Mario Draghi to "do whatever it takes" to assure the survival of the euro. Draghi not only eliminated any ambiguity about where the ECB stood, he also brought out the "big gun" of Outright Monetary Transaction (OMT). This instrument commits the balance sheet of the bank to ensure the liquidity of European financial markets. Draghi was rightly commended for his decisive handling of the crisis more than a year ago, but he had no choice: Europe was, I think, at the edge of a financial catastrophe; failure to act would have been unthinkable.
The second factor that helped quell the worst fears of financial markets was the commitment made by euro zone leaders to work towards a true banking union. (Recall the pressure brought to bear by others at the G20 summit in Los Cabos, Mexico.) Of perhaps most importance was agreement on the need for ECB supervision of systematically-important banks and the decision to subject the euro zone's banks to credible stress tests.
Together, these developments calmed the troubled waters of the euro zone and provided breathing space for much-beleaguered governments. Moreover, the effectiveness of the OMT was a boon for economists, who have gone through first, second, and third generation models of financial crisis. In fact, it could be argued that the success of the OMT vindicated all those who had posited the potential for economies to exhibit multiple equilibria, with the outcome determined by shifts in expectations. The mere announcement of the OMT eliminated the immediate threat of euro zone collapse and allowed investors to price in the possible adoption of policies that would transform an imperfect currency area into a more perfect union.
But, for the avoidance of doubt, it should be noted that the OMT has not been tested; should some external shock once again raise existential concerns, markets may test the ECB's ability to back up its bravado by putting its balance sheet where its communiques are. The problem is that — how to put this — not all members of the euro zone are equally enthusiastic about the idea of the OMT. Moreover, while some progress was made in terms of banking union, particularly in terms of supervision and stress testing, the outcome is far short of the ideal. In particular, the costs of bank failures will be borne by national governments. (So, periphery governments with insupportable debt burdens would be required to cover the costs of bailing out bank depositors and bondholders ...).
What might those "external shocks" that test the robustness of the new-found stability be? I can think of three. First, the German constitutional court is to rule on the constitutionality of the ECB's extraordinary measures. A negative decision could lead to renewed speculation about the future of the euro zone. Second, the prospective tapering of the Fed's quantitative easing has focused investors on their portfolio allocation decisions; higher global interest rates isn’t what the doctor ordered for the periphery and a "risk-off" moment might have negative consequences for the euro zone. And, third, there is the continuing risk of deflation in Europe, which increases the real burden of debt. Unless strong growth is quickly restored, watch for increasing poverty and growing social unrest. History teaches that should this scenario unfold, political systems would very likely deliver unorthodox policies “destructive of national and international prosperity.” Such policies are generally not positive for rentiers.
Any of these shocks could trigger renewed fears for the euro zone. In this regard, it would have been better for Europe’s leaders to resolve to address the root causes of the malaise; not merely predict that "when the storm is long past the ocean is flat again.”