NO HAPPY NEW YEAR FOR THE EUROZONE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

No happy new year for the eurozone

By Wolfgang Münchau

Published: January 9 2011 20:10

European crises respect the holiday season. This is old Europe after all. The acute bond market crisis came to a halt mid-December, and resumed last week. It could have been a holiday season of thought and reflection. But it was a season of complacency. At the December summit, the European Union missed a historic chance to get on top of this crisis. We will do whatever it takes, they swore, and went home.


Nobody believed them, but the panic did not start until last week, when bond yields rose, and the euro slumped. Of all the metrics of market panic, perhaps the most telling was the rise in the Markit iTraxx SovX Western Europe Index. This is a basket of mostly eurozone sovereign credit default swaps, which rose, for the first time, above the level of a similar index for central and east Europe. Just pause for a second and consider the momentous shift that has taken place: western Europe is now considered a higher risk than central and east Europe.


It is wrong to think of this as a crisis of small countries in the eurozone’s distant periphery. It is a crisis of the core eurozone as well, and it is spreading fast. Last week Belgium got on to the radar screen of international investors, when sovereign credit default swaps reached new records after the umpteenth attempt to form a Belgian government failed.


This year, Belgium’s national debt will surpass 100 per cent of gross domestic product. It also has the highest exposure of any European country, relative to gross domestic product, to Irish debt. It badly needs a strong government to take unpopular decisions to sort out its banks, reform the social security system and bring public finances back to a sustainable long-term trajectory. As the political leaders of Flanders and Wallonia continue to fight their petty battles, Belgium is losing the war to secure long-term economic stability.


Italian 10-year bonds yields have also steadily crept up over the past month. The danger in Italy – again from an international investor’s perspective – is political instability of a similar kind in Belgium. A leading Italian intellectual once remarked when asked about a hypothetical break-up of the euro that Italy was more likely to break up than the eurozone. I think he was only half-joking. Italy, like Belgium, is an economically and politically divided country, and has a similar debt-to-GDP ratio. Fortunately Italy has a much more robust banking sector, though productivity is poor. It would not be an outrageously hypothetical proposition to suggest the post-Berlusconi world of Italian politics would turn even more chaotic. In that case the country might end up with similar divisions as Belgium with pressure for extreme devolution and a weak central government.


You cannot really blame investors if they regard a well-functioning central government as a solvency prerequisite for countries with a debt-to-GDP ratio of 100 per cent. Lack of political leadership at both national and European level is the reason why the crisis is spreading.


The most glaring manifestation of this lack of leadership is the EU policy consensus that this crisis will eventually be self-correcting, and that a robust liquidity backstop is all that is needed. This is a tragic error. What makes this crisis self-sustaining is the presence of two interacting components: a combined private and public sector solvency crisis, and a competitiveness crisis. To address a lack of competitiveness, southern Europe, including Italy, would need outright deflation. In some cases wages and prices would need to drop by 30 per cent to fall in line with northern eurozone levels. Yet deflation would increase the real value of debt. It may just be conceivable that the periphery will get on top of their competitiveness problem, or on top of the debt problem, but surely not on top of both at the same time, without devaluation or default.


The competitiveness problem may not be the more urgent of the two, but possibly the more important. Internal imbalances are still widening. So is the competitiveness gap. Spain in depression still generates higher inflation than Germany in a boom. December inflation rates were 2.9 per cent in Spain, and 1.7 per cent in Germany.

The longer this dual crisis drags on, the more radical, and improbable, any solutions would have to be. In my view, the crisis is insoluble without a Europeanisation of the banking sector, common labour and product market rules that prevent inflation stickiness in southern Europe, and a minimal fiscal union with a single European bond. This is not a complete list.

Europe’s political establishment is of the opinion that such a radical response is unwarranted and politically infeasible. The first assessment is wrong. As the world comes out of its Christmas stupor, it discovers the second may well be right.


Copyright The Financial Times Limited 2011.