Steinbock: The Worst Days Are Still Ahead for Europe

After two years of debt crises, the Eurozone’s pro-austerity and pro-Euro policies are in trouble. With increasing uncertainty comes rising volatility in markets.


On Sunday, 17 years of right-wing rule came to an end in France as François Hollandeswept into office. Socialism did not win; the anti-Sarkozy did.

In Greece, the incumbent conservatives and socialists were expected to take a beating. What was not expected was the dramatic reset of Greek political landscape as the Coalition of the Radical Left took second place, trailing only conservative New Democracy and leaving socialist Pasok to third place.

In Germany, the junior coalition partner the FDP gained in state elections, while the support of CDU, Chancellor Angela Merkel’s dominant party, is eroding. Merkel reigns at the federal level, but the FDP is making overtures to the Social-Democrats and Greens about possibly governing together in the future.

The message is loud and clear. Pro-austerity policies are in trouble.

End of consensus?

Ever since the onset of the Eurozone crisis in spring 2010, Brussels has played a second fiddle in the region as the de facto power in the region has shifted from the bland technocrats of the European Commission and European Council to inter-governmental decision-making.

For all practical purposes, the Eurozone has been led by Germany and France. Now this status quo is crumbling.

During the past two years, the conservatives – from James Cameron’s coalition in the UK to Merkel’s coalition in Germany – have been promoting the pro-austerity, pro-Euro approach. The latter has been based on front-load austerity measures and promises of long-term fiscal support

The new approach is based on anti-austerity, but pro-Euro approach. Behind this political backlash, there is a huge demand for immediate fiscal support and back-load austerity measures.

In the past three months, some analysts argued that the Eurozone uncertainty has been contained. In reality, the region only enjoyed a brief time-out, not an absolution – thanks to the European Central Bank (ECB) .

The ECB timeout is ending

Under Jean-Claude Trichet, the ECB hiked the interest rates, which aggravated the crisis. Since last fall, the new ECB chief Mario Draghi has reversed this policy, while pushing two massive long-term refinancing operations(LTRO) across the Eurozone.

A few days ago, Draghi made it clear that the ECB does not intend to conduct still another massive liquidity injection, given that the past operations in December and February have prevented a credit crunch. In reality, this crunch is very much alive and underway in Southern Europe.

Recently, the ECB also left main rate unchanged at 1%, which dampened hopes for further non-traditional measures in the Eurozone.

The ECB does not have the mandate of the Federal Reserve, and Draghi is not Ben Bernanke.

As the ECB left the ball in the court of governments and banks, it presumed that the former would continue the old pro-austerity pro-Euro approach, while the banks will succeed in their recapitalization efforts.

Neither assumption is any longer fail-safe.

Leaking firewalls

In addition to fiscal and monetary policies, as well as the ECB dilemmas, the Eurozone remains haunted by a host of other challenges.

Last November, the Eurozone countries agreed that 70 major euro banks must raise EUR106 billion by mid-2012; later the target was raised.

As the Eurozone is sinking deeper in a recession, it is only sensible to expect bank turmoil, especially as Brussels’ projections of the euro banks’ capital needs continue to ignore massive losses that these banks would accrue from debt restructurings.

At the end of March, the Eurogroup announced a combined European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) lending ceiling of EUR 700 billion (effective EUR 500 billion ESM plus running EFSF programs at EUR 200 billion).

Despite some additional funds, even this firewall is not enough to deter runs on Italy or Spain, which together account for more than 25% of the Eurozone GDP. Even if the lending ceiling were to be doubled, that would not save the “too big to fail” major economies in the Eurozone.


Preparing for worse

Ultimately, the European challenges cannot be resolved without appropriate pro-growth policies, which require substantial structural reforms, including more flexible labor markets, higher retirement ages, greater investment into innovation, and so on.

However, the mandate of the new and aspiring leaders in Europe is to reverse the nascent structural reforms and to overcome the debt crises. If politics is the art of possible, this is but another futile effort to buy time.

In the next few months, the masquerade will end. Ultimately several Eurozone members must restructure their private and public debts, while a few may have to exit the monetary union. Greece is only the first in the line.

The Eurozone crisis is not even close to its end. It has only begun. And the worst days are still ahead.

Dan Steinbock is research director of International Business at India China and America Institute (USA), visiting fellow at Shanghai Institutes for International Studies (China) and in the EU-Center (Singapore).