The mood has turned against austerity in the euro zone because it is now rightly seen as anti-growth. The question is what next. Here I will hazard a few predictions of where euro zone policy is headed.
Let’s use the framework I set out when framing the political economy of the European sovereign debt crisis last summer. I think the main social psychology component of this framing was in talking about how policy adapts when policy makers have publicly committed to one that is ill-suited for the economic circumstances. I spoke a bit about policy inertia in the context of wanting to provide some modicum of consistency. This is part of what supports any status quo. But as the policy starts to visibly fail, the questioning of the status quo increases and the status quo becomes unstable.
What invariably happens is some sort of minor shift toward addressing the symptoms of the problem – in the euro zone case, bank and sovereign insolvency and high private sector indebtedness in a fixed exchange rate environment. But, until seismic voter changes occur, the modus will be ‘extend and pretend’ i.e. treat symptoms instead of root causes in the hopes one can muddle through without more drastic policy change.
Right now, what we have seen – with double dip recession in the euro zone and the re-coupling of Spain to the periphery – requires policy makers to shade their policy responses toward growth and away from austerity. It is now clear to all politicians in the periphery that austerity and growth are mutually exclusive and that choosing austerity over growth will result in political suicide. Finally, Merkel and Schaeuble have got onside and have voiced a commitment toward a growth pact. However, the economic imperatives for Germany are different than they are in the periphery. So, when Merkel and Schaeuble say ‘growth compact’, they still mean something different than Francois Hollande or Mario Draghi. My expectation is that European policy makers will close this gap through negotiation and that some sort of growth pact will be unveiled. Whatever growth pact gets unveiled will be a swag – something not fully growth oriented that also lets up on the Maastricht 3/60 rules. This will be in line with the extend and pretend approach that has Europe lurching from crisis to crisis because the economic situation requires more of a policy shift than policy inertia will reasonably allow. So at a minimum I expect the 3/60 rule to be inactivated or relaxed but I still expect the EU to require fiscal consolidation. Eurobonds still seem to be a non-starter.
That’s the one. So that’s fiscal policy.
The second to think about is monetary policy. There really hasn’t been much movement here since the introduction of the LTROs to save Italy and Spain through the back door. If you recall, in November and December, central bankers were reminding us that central banks only act as lenders of last resort to banks and not to sovereigns. This was prelude to their 3-year LTRO to banks that has effectively served as a sovereign backstop as well. However, we have seen that this is not enough. I said early in the year it would not be and that the ECB would need to make its sovereign backstop more explicit. But this is a much stickier wicket than the fiscal side. At this juncture, I am not sure what kind of policy swag the ECB can come up with that will provide terms consistent with the no sovereign bailout clause but prevent the situation in Spain and Italy from deteriorating without involving the banks. I don’t see any but none is needed quite yet. Bond yields are not at the terminal phase, though for Spain they will be there soon. By the time 10-year bond yields hit 7% in Spain, the ECB will be forced to do something or we will have to get Eurobonds. Again, we’re not there yet. So maybe we can get another swag that extends policy space before that comes. I still expect more explicit ECB sovereign backstops by year end. It isn’t clear yet how they will get there or what those backstops will be.
So that’s monetary.
What I think monetary reveals is that it is inextricably linked to the banks. And so I expect this last leg here to play a crucial role. What I suggested last week is that the Spanish bailout may be to recap the banks instead of the sovereign. If the banks can directly access the EFSF and the ESM like a EuroTARP then the banks will be recapitalised on a European-wide level. Moreover, German banks, being undercapitalised, will also need to get EuroTARP funds and so reasonably the Europeans can claim this is not a bailout of the periphery but of the banks. While European voters might grumble about this, given Basel III is looming, I expect they would accept the need to raise more bank capital and that using the ESM/EFSF money is a cheap way of doing it. The goal here would be to divorce the bank – sovereign co-dependency, which would eliminate the sovereign questions for Spain and bring the crisis back to more of a simmering crisis from its present level approaching the boiling point.
I will be watching these two points and updating you as the situation changes.