The next five years of the euro crisis

The next five years of the euro crisis: Five key questions

Bulletin article
01 December 2010

Will the euro break up?

The euro crisis is rooted in structural imbalances that even on an optimistic scenario will endure for years. Germany has a current account surplus and weak domestic demand, while Greece, Ireland, Italy, Portugal and Spain - after years of profligacy - suffer from current account deficits (Ireland excepted) and low growth. Nothing the EU is doing will close the gap in competitiveness between Germany and the problem countries, nor provide the demand that would allow the latter to grow their way out of trouble. These countries face a painful combination of public spending cuts, a suffocating debt burden and perhaps social unrest.

The creation of a 'fiscal union' - with cash transfers from prosperous countries to poor ones - could help to revive the eurozone. But neither Germany nor the other rich states want to write the cheques or transfer significant new powers to EU institutions. The financial markets have not yet focused on Italy, perhaps because its budget deficit is modest. But Italy's leaders are dangerously complacent. Like Greece, Portugal and Spain, Italy suffers from very high public debt, poor productivity, lost competitiveness and low growth. Yet while those countries have begun to embrace structural reform, Italy - whose size would make it very hard to bail-out - has not.

Yet despite all the difficulties, the euro is unlikely to crack. Many Anglo-Saxons under-estimate the strength of the political will that underpins it. EU leaders - even, ultimately, in Italy - will do whatever it takes to save the euro, short of setting up a fiscal union. They will sign up for bail-out after bail-out, persuade their parliaments to provide the money and swallow whatever losses may ensue from debt restructuring. The rich countries will not want to push any country out of the euro, lest market contagion grip another. Nor would a badly-indebted country be likely to want to leave: as soon as its leaders talked of withdrawal, money would shoot out and the economy would risk collapse.

But might Germany itself quit? Many German citizens think the euro a burden and dislike the idea of their country bailing out profligate southerners. But Germany's business and political elites know the economy does very well out of the euro. German exporters have a captive market of uncompetitive countries that cannot devalue and that buy their goods. German leaders have failed to explain the benefits of the euro to the people and need to do so. But though Germany is more assertive of its interests than it used to be, it remains broadly pro-EU. Its post-war identity as a country committed to European integration is incompatible with the idea of leaving the euro and thereby wrecking the EU.

Will Germany continue to lead the EU?

The crisis has made Germany the EU's undisputed leader. That is not surprising, given that it provides the biggest share of all bail-outs, and its relative economic success. Other countries - including France - now measure the credibility of their economic policies by watching how much more their bonds cost than those of Germany. Chancellor Merkel said she wanted a treaty change to set up a crisis resolution mechanism, and that the mechanism should make private investors take a hit. France's President Sarkozy - like most EU leaders - opposed both ideas but then bowed to German pressure.

French leaders tend to think German economic policies make the eurozone's problems worse. So why does Sarkozy follow Merkel? The French worry that the growing economic divergence between Germany and its less successful partners could make it reluctant to work through the EU. Sarkozy seems to think that the best way to maintain some influence over Germany is to support its euro policies.

Merkel will probably get her treaty change. The 27 governments will follow a 'simplified procedure' that can only be used for an amendment that does not grant the EU new powers. They plan to ratify by parliamentary votes and to avoid referendums (though in some countries the courts may be asked to rule on whether a referendum is required). Vaclav Klaus, the Czech president, could repeat the games he played with the Lisbon treaty, delaying its ratification. But if all goes smoothly, the amendment will be ratified before the existing bail-out fund expires in 2013, just before the next German general election.

The smaller countries - and the Commission - have so far gone along with the deals struck by Berlin and Paris, albeit reluctantly. But France and Germany will need to treat them with more sensitivity if they want to avoid a rebellion. Slovakia, for example, has already refused to join the Greek bail-out. Germany will keep leading. But if the EU's Berlin-led strategy for curing the euro's ills is seen to fail, the Germans will meet resistance.

Are there any rays of light in this dark picture?

 In five years' time the problem countries are likely to be better managed than today, thanks to market pressure. The German medicine of belt-tightening and large doses of structural reform may foster investor confidence, spurring productivity rises and even some growth. Meanwhile Germany may evolve. Its leaders do not like being told that they should rebalance the economy. But plenty of influential Germans - including those in positions of power - know that their country needs to boost investment and consumption, and become less export-dependent. Furthermore, Merkel has agreed to new EU procedures that will allow the Commission to monitor imbalances in the eurozone, and recommend policy changes.

The German government may embrace reforms that would help rebalancing - such as increasing competition in services, the number of women in the workforce, and shopping hours. And there are tentative signs of domestic demand growing. Lower unemployment is pushing up wages, which are expected to rise by 3 per cent in 2011. The Council of Economic Advisers predicts that domestic demand will drive most growth in 2011 - because of weakening export performance and a (very modest) 1.6 per cent rise of consumer demand. The sooner the German economy rebalances, the better for the southern countries, and the euro.

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