Judy Asks: Will the Eurozone Crisis Come Back?

Yes and no (or “jein,” as the Germans say). Europe is not headed back to the days of 2011–2012 when a Greek exit from the eurozone was seen as an existential threat to the single currency bloc and investors were nervously watching the surge in bond yields across Southern Europe. But the EU may be entering a different kind of crisis—one that is more political than financial and in which Euroskepticism spreads to the heart of the eurozone.

Both France and Germany have elections coming up in 2017. And in each country, the political establishment faces a threat from a party that openly questions the benefits of the euro and of the EU. In Berlin, politicians from Chancellor Angela Merkel’s conservative bloc are railing against the loose monetary policies of the European Central Bank, in part because they fear the populist Alternative for Germany will use this issue to their advantage. In France, one can expect more Europe-bashing than usual during the election season because of the strength of the far-right National Front and the weakness of the economy.

Meanwhile, if Britain votes to leave the EU in the referendum to be held in June, it will be hard to counter the sense that Europe is disintegrating after over a half century of integration. To achieve this, the eurozone would need to unite behind a vision of an ever-closer union. But with Berlin and Paris at odds over what that union might look like, and their citizens increasingly questioning whether they even want it, the chances of Europe and the eurozone sinking deeper into crisis are uncomfortably high.

The year 2017 will mark the tenth anniversary of the start of the global financial crisis that led to the eurozone’s woes. Arguably, consensus exists on what made the post-2007 incidents into a crisis: collapsing asset prices, a risk of bank runs, global and national credit squeezes, a massive recession in terms of severe drops in economic activity, and seemingly irrevocable rises in national unemployment rates. At the roots of the crisis were poor and unsustainable lending practices of financial institutions and, less popular, politically negligent delays in structural economic reforms at the level of the EU member states.

What has changed so far? Not much at all. Risk premiums have increased for public borrowers but have not prevented governments from accumulating ever more public debt, despite the EU’s verbally reinforced fiscal rules. The size of major financial institutions has increased, worsening the eurozone’s problem of moral hazard once again.

What is new? The European Central Bank has taken on the role of a commercial bank, effectively pushing public sector debt to ever-higher levels, but without control over the monetary transmission mechanism, let alone the political lever to enforce structural institutional reforms in member states.

Will there be another crisis? In terms of severe asset market volatility, most likely yes, sometime in the future. In terms of a renewed recession, probably not in the near future. But stagflation is likely to continue to be a core characteristic of eurozone economies unless member states manage to create a real single market for the 70 percent of European economic activity that is still governed—and often protected—by national laws.

The eurozone crisis never ended. It was acute, now it is chronic. Some countries, such as Ireland, are clearly emerging. But everywhere the legacy of the crisis remains in the form of much higher government debts. Greece’s nth bailout drama, Spain’s unemployment and political mess, and Italy’s huge nonperforming loans are some of the most visible symptoms.

Will countries go back into the emergency room? Or will they need resuscitation, like Greece? Given modest but steady growth in world GDP, a devalued euro, rock-bottom oil prices, and easy money, all of which exist today, I expect neither.

But good weather does not last forever. For countries like Italy, the clock is ticking. The refusal of Germany, the Netherlands, and others to restructure Greek debts—as the IMF insists they should—is irresponsible. Contagion from the next Greek crisis may not be as easily contained as in the past.

Did the eurozone crisis ever go away? Not if you ask the Greeks or the Portuguese. Of course there will be major new turbulence, though probably not in 2016. Economic imbalances, financial fragilities, fragmentary policies, and disjointed eurozone governance will see to that. But the crisis—as a force powerful enough to tear the eurozone apart—will almost certainly not come back.

I hear the cries of the doubters. Why my optimism? It’s politics. Since 2008, eurozone policy actors have always found just enough fortitude and wisdom to keep the show on the road. All sides had to swallow a little pride and prejudice and became much better for it. The European Central Bank is less Germanic, the Greek far-left Syriza party is less radical, and Spanish politics are less sclerotic—who complains? Most importantly: nowhere did voters elect to pull the plug on the euro, despite the economic pain and the political angst. Why is no one saying that most elections since 2008 were effectively referenda on the euro and that the euro won all of them?

All good then? Certainly not. Yes, the eurozone is anchored in popular will: voters know that the disintegration of the single currency would put Europe’s precious post–World War II integration settlement at risk. But a currency needs a budget, taxes, a parliament, and a government. As long as the euro has only some of these features, it will remain more exposed and less resilient than the U.S. dollar.

So more crises will occur—less threatening than the first one, but threatening enough until the EU gives the eurozone the government it needs. That will happen because integration will continue to beat disintegration. But sadly, for it to occur, one crisis will not be enough. Per aspera ad astra.

The most acute phase of the eurozone crisis has, thanks to European Central Bank President Mario Draghi, been left behind. Nevertheless, Europe is far from declaring the crisis an ugly experience of the past. Growth remains weak if not elusive, unemployment is persistently high, banks are still in poor health, private and public debt is disturbingly high, and unfunded public sector liabilities have not been brought under control.

Notwithstanding some positive signs, especially from Spain, the peripheral economies, first and foremost Greece’s, have long been asked to follow a course of austerity, internal devaluation, and labor market deregulation that has produced only fragile outcomes. In the case of Greece, this approach has led to considerable and most likely irreversible economic and social pain.

Eurozone governments have collectively opted for a policy of weak crisis management—of the pretending and extending variety—and longer-term institutional reform. Thus, the burden of crisis management has been placed largely on the European Central Bank, even though doubt has been cast on the efficacy and legitimacy of the bank’s unconventional policies. Furthermore, institutional reform has hardly made the eurozone crisis-proof, as the EU’s banking union falls short of real needs.

Institutional reform should opt for either fully fledged fiscal federalism or genuine fiscal decentralization associated with unhindered market discipline. Going the middle way, albeit in a quantitatively different form this time from in the precrisis period, will likely lead the eurozone once more into the worst of all possible worlds.

Since taking office in February 2014, Matteo Renzi, the young and energetic Italian prime minister, has done a lot to insulate his country from a future market crisis. Renzi’s government launched an aggressive economic and political reform agenda, which his predecessors had been unable or unwilling to enact. He has also vigorously courted international investment, in an attempt to attract foreign capital to nourish Italy’s recovery. In terms of Italy’s bond yields, he has been successful: ten-year government debt was trading at 1.3 percent in mid-April 2016, a far cry from its level above 7 percent at the height of the sovereign debt crisis in late 2011.

But the sense that a meltdown could be around the corner has not evaporated completely from the eurozone’s third-largest economy. The worry is that it may simply take a different form, starting with the poor health of Italian banks, which are shouldering a huge pile of nonperforming loans that are the legacy of the deep and lengthy recession—and of the country’s unwillingness to use public funds to bail them out. Alarm bells rang in Rome and Milan when Italian banks were among the worst performers in the global financial market rout that hit in January 2016, and despite numerous attempts by Renzi’s government to tackle the problem recently, that vulnerability does not appear to have been erased.

An Italian banking crisis would inevitably have negative repercussions on the country’s economy and fiscal position. In that case, those low government bond yields so carefully nurtured by Renzi could, unfortunately, start rising again.

The euro crisis never went away and will worsen sharply once the economic cycle turns. The eurozone is struggling to grow by more than 1.5 percent a year, at what is likely to be the peak of the economic cycle and with output scarcely back to precrisis levels. The single currency bloc still lacks essential institutions such as a fully fledged banking union or a mechanism to transfer funds between member states. Nor is there coordination of macroeconomic policies to ensure an adequate level of demand across the currency union.

The eurozone will in all likelihood enter the next downturn with interest rates at zero and with high levels of debt and unemployment. The European Central Bank will not be able to cut rates, and those member states most in need of fiscal stimulus will have least freedom to impart it. The result will be a renewed recession in countries that will not have recovered from the previous one, against a backdrop of persistently strong support for populist parties, and with banks still weak and still essentially backstopped by weak sovereigns.

At this point, it will be make-or-break regarding the big institutional questions. It’s possible eurozone governments will bite the bullet and agree on genuine risk-sharing federal institutions. But it is just as likely they won’t.