Solving euro crisis becomes ever more complicated

This week began with the announcement of the IMF’s growth projections, which were downgraded for virtually every large economy. Although this was nothing new or unexpected, and the financial markets seem to have priced in the scenario of a global growth slowdown, the IMF also noted that the forecasts were based on the assumption that the Eurozone crisis would be tackled shortly.

 

Unfortunately, this is not what Eurozone leaders are working on now. The debate between politicians of the core euro countries and of the peripheral countries is still unresolved. Economically, it is quite clear that what needed is a banking, fiscal, and eventually a political union, in combination with a larger firewall in the form of an expanded ESM. The problem is how to get there. Logically, the peripheral countries first require that something is done about the prohibitive interest rates. After all, if governments must pay an ever higher price to finance themselves, any effort to reduce deficits is immediately offset by rising costs to sustain the already too high debt burdens. On the other hand, the core countries logically require that there is first oversight of the Eurozone banking sector and that countries hand in a degree of sovereignty over their budgets before the core pledges additional financial support. After all, why should these countries write a blind check as they do not have control over how their money is spent?

 

Two events are complicating the situation further, rendering a solution further off:

• The entire Eurozone is weakening and many core countries are also ordered to put their government finances in order. In the Netherlands, for example, a guarantee of €6bn for the Spanish banks equals 1/3 of the vastly unpopular austerity measures recently announced. Clearly, resistance to extra financial support is growing and so the window of opportunity to reach a solution is closing down.
• With more core countries weakening, the group of ‘peripheral-like’ euro countries is growing, and so is their say in how Eurozone institutions and policies are shaped. A notable example is France, which is dealing with an eroded competitive position and consequentially a twin deficit. The Merkozy couple was able to push through some unpopular but necessary deals, but the election of the socialist president Hollande put an end to this leadership duo. With elections looming in the Netherlands as well, prime minister Rutte refrains from comments about how Eurozone institutions should be shaped, afraid that this will lower his chance of reelection. His approach that first the short-term issues should be solved, ignores the economic reality that the lack of a viable long-term plan is exactly what is causing rising tensions in the financial markets. Shortly, the number of strong countries is shrinking, which limits their political and economic muscle power, while impending elections discourage political brinkmanship.

Incidentally, with the entire Eurozone expected to weaken further, and the weaker the influence of the core euro countries, the more difficult it becomes to take decisive action to tackle the Eurozone crisis. Many analysts are already labeling the European debt saga as a structural issue. Will they be proven right?

Without any Eurozone summit planned shortly (and leaders overcoming their fears to appear weak when they are actually pushing forward with the necessary reforms), rising financial market turmoil is all but unavoidable. Read our Eurozone interest rate or Global Financial Markets reports for further insights about whether a solution will eventually be reached, and what this entails for interest and exchange rates.