Is Europe still in crisis?

Rewind to two years ago, and it seemed to be all over for the beleaguered euro. Spreads were off the scale, the banking system looked close to collapse, and words such as “eurogeddon” were part of the everyday lexicon. The single currency’s obituaries were being widely prepared, while here in the UK they had already been written.

Originally in a state of denial, even the politicians had by November 2011 apparently accepted the inevitable. Confronted by the announcement of a Greek plebiscite on the terms of the latest bail-out, an exasperated Nicolas Sarkozy, then President of France, broke the final taboo and publicly acknowledged that some countries would be unable to make the cut.

This admission set in train a mass panic in financial markets as the full implications of a break-up began to sink in. If Greece had to leave, then other, bigger distressed economies such as Spain or even Italy might be forced out, too, triggering complete meltdown in Europe’s banking system. The economic abyss seemed to beckon.

Now fast-forward to today, and much of Europe’s economy is engulfed by a depression of unprecedented intensity, the euro still exists in its original form, and talk of a break-up has receded to the point of virtual invisibility. Not a single member has been forced out. In fact, the currency has even gained a new member – Estonia – and there seems to be a long queue of others apparently keen to sign up. What’s more, there are even signs of economic revival. In the second quarter of this year, eurozone GDP rose by 0.3pc, or an annualised rate of 1.2pc. Business surveys last week suggested that this upturn has continued into the third quarter. So can we finally bid farewell to Europe’s most serious crisis since the Second World War?

Would that it were so. For the next flashpoint, look again to Greece, site of the original infection. With the German general election looming next month, there’s been a determined, though not entirely successful, attempt among eurozone leaders to pretend that the Greek problem has been solved, and that it’s all onwards and upwards from here on in. Unfortunately, it is only a matter of months before it rears its head again.

This article attempts to answer four questions: how the euro has managed to survive thus far; whether the European economy genuinely is on the road to recovery; what still needs to be done to ensure a sustainable and successful monetary union, and how likely it is that these things will be done. None of the answers gives much cause for optimism.

The first question is perhaps most interesting, for the euro’s resilience seems to defy Margaret Thatcher’s dictum that when politics and economics collide, it’s always the economics that will win.

The most important thing to recognise about the euro is that it is primarily a political project, not an economic one. If economics had ruled, then it would never have been attempted in the first place, or not on the ambitious scale embarked upon. Even among supporters of the single currency, there is now widespread recognition that the euro in its current form was at best premature; Europe wasn’t ready for monetary union, and as a collection of still proud sovereign nations with very different cultures, legal systems and more, perhaps it never will be. Many of the countries that joined at the turn of the century were nowhere near fit for the euro’s disciplines, with inflexible labour markets, bloated welfare systems and endemic levels of corruption. That these economies could happily co-exist with a highly competitive German core was always something of a case of wishful thinking.

Yet outside Britain, Sweden and Denmark, everyone appeared desperate to join – it seemed against the spirit of “ever-closer union” to deny them. It was also widely believed that the euro would act as a galvanising force, compelling necessary reform and disciplines.

As a result, the rules were widely manipulated to allow all-comers to join. Reluctantly, Germany went along with the pretence, even though it was more aware than any of the dangers.

Nevertheless, the euro chugged along happily enough for the first five or six years. The launch was a triumph of German efficiency and planning, and for some formerly highly unstable economies, such as Spain and Italy, the new currency seemed to be an overwhelming positive.

From the start, however, the straitjacket of monetary union was incubating serious problems, imbalances, and in some countries, potentially destabilising credit booms. Far from providing once-wayward economies with the necessary disciplines to succeed, the euro did the reverse, by removing the constraints markets normally impose. Eventually, the single currency became like a pressure cooker ready to explode. With no means of adjustment through the natural market remedy of free-floating exchange rates, major trade and capital imbalances established themselves. Low interest rates led to construction and consumer booms in the eurozone periphery, adding to wage inflation and making deficit nations ever less competitive against the German core. These deficits were financed by a matching savings glut in surplus nations.

The banking crisis cut these flows off, further weakening the banks in deficit nations and creating a parallel sovereign debt crisis. Europe seemed to be in meltdown.

Yet though much criticised for a slow and inadequate response, the reality is that Europe has moved with a quite surprising degree of resolve and effectiveness to patch up the project. No one would pretend that the raft of institutions and initiatives put in place to keep the show on the road does any more than paper over the cracks, but given the obvious difficulties of achieving consensus between 17 member states with very different priorities and interests, progress has been remarkable.

A bail-out fund was quite quickly established and applied to countries denied market access. In the teeth of fierce opposition from the German Bundesbank, the European Central Bank has also begun to operate like a proper central bank should, by offering unlimited liquidity to the banking system and promising to do the same in sovereign bond markets should governments need it. Together, these measures have succeeded in calming the storm.

But although these actions have undoubtedly bought time, they have not addressed underlying problems of solvency, competitiveness and imbalances in trade. Furthermore, the austerity programmes imposed on eurozone nations in an effort to halt the rise in sovereign indebtedness has deepened the economic malaise, causing unemployment in deficit countries to reach socially intolerable levels.

Yes, some sort of a recovery seems to be establishing itself – albeit one focused mainly on the already relatively robust German core. In the depression-engulfed periphery, it is more a case of the rate of contraction merely slowing.

In Spain, where unemployment is at a scarcely believable 27pc; in Greece, where more than half of the nation’s youth is unemployed; and in Ireland, where property prices have crashed, there is little to cheer about.

What cannot be denied, however, is that none of this seems to have shaken political, or even popular, faith in the euro. Here in Britain, we find it impossible to understand why any nation should wish to inflict such punishment on itself. But to many Europeans, the euro is about so much more than a mere monetary mechanism. However malfunctioning it might be, it also seems to represent liberation from past tyrannies, modernity, relevance, and that most precious thing of all, European cohesion and solidarity after centuries of warring destruction.

It has become something of a cliché to call the euro a religion, but few other words better describe its blind disregard for economic realities. People want to believe. There is another reason, too, why it has held together – fear of the consequences of leaving.

Even the deprivations of depression, loss of fiscal sovereignty, and in some cases the removal of democratically elected governments, seem preferable to the economic chaos that would undoubtedly await any exiting country. More solvent members are equally wary of the crippling losses any exit might impose on their own banking systems. There is a sense in which countries would not be allowed to exit even if they wanted to.

In any case, the patient has been prevented from dying on the operating table, but only to relapse into a state of chronic, long-term illness. Current account deficits have been closed – even Greece is now back in surplus – but only via the brutality of stifling internal demand, causing unemployment to rocket. This in turn has further increased the real burden of public and private indebtedness. If shrinking the economy counts as improved competitiveness – which is what Olli Rehn, Europe’s economic commissioner, implies when he says that policy is working – then things really have reached a pretty pass.

With economic contraction doubling up the task, and pain, of deficit reduction, there has of late been some paring back of the austerity agenda.

Most countries have been given more time to reach deficit reduction targets. But since they weren’t going to meet them anyway, this only recognises a practical reality, rather than amounting to a significant change of heart or policy.

Europe still has no convincing answer to destructive levels of unemployment. Nor does it offer debt-encumbered peripheral economies a plausible path back to growth.

Some hedge fund managers believe that once safely re-elected, Angela Merkel, the German chancellor, will finally feel safe enough to provide the kind of leadership necessary to bring about a sustainable monetary union. Such measures must include fairly rapid movement towards a fully-functioning banking union, with a single bail-out mechanism, common deposit insurance and a unified resolution regime.

Some form of sovereign debt mutualisation is also required to stabilise markets and bring about the requisite degree of burden-sharing between creditor and debtor nations. None of these things would be possible without the political institutions to give them democratic legitimacy. Yet there is nothing in the German chancellor’s rhetoric or policy record to think any of them remotely likely.

A cautious politician by nature, there is no evidence that Merkel might be considering such a revolutionary series of changes, even if she thought them appropriate, and there is even less evidence of that. For her, the euro is Germany’s new Deutschemark. A certain amount of accommodation and compromise is regarded as necessary, but there are red lines beyond which she will not tread.

But hasn’t her position throughout this crisis been characterised by retreat? This is true enough. On a number of occasions she has dug in her heels, only eventually to be pushed into more concessions.

Another such denouement is threatened soon after she is re-elected, with the epicentre of the crisis returning to its old stamping ground, Greece. Athens needs both more money on top of existing programmes and a further restructuring to stand any chance of reaching debt sustainability. Throughout the election campaign, Ms Merkel’s Christian Democrats have studiously tried to avoid all discussion of this politically toxic issue. When it could be avoided no longer, her finance minister, Wolfgang Schaeuble, mentioned it only to insist that although another programme for Greece was inevitable, there could be no question of further debt forgiveness.

This is not what the International Monetary Fund, or indeed Germany’s own Bundesbank, believes. A recently leaked Bundesbank report on the issue observed that not only would there have to be further restructuring, but since virtually all Greek sovereign debt was now owned by eurozone bail-out funds and the European Central Bank, the next write-off would obviously have to involve previously immune official creditors.

The Greek bail-out would thereby transition from the present charade of lent money, which will at some stage be repaid, to an outright fiscal transfer. This would be a breach not just of European treaties, but more significantly, the German constitution.

On several levels, then, the belief that the eurozone crisis has gone away, or even that Europe is on the mend, is just more wishful thinking.