In 2011, the world watched as the sovereign debt crisis in the eurozone went from bad to worse. A series of make-or-break summits, rescue packages and austerity budgets failed to solve Europe's problems and allowed the economic turbulence to rumble on. As we enter the new year, the situation seems bleak: the financial safety net for countries experiencing funding difficulties has some significant holes, contagion has spread across southern Europe from Greece and Portugal to the much larger economies of Italy and Spain and, despite plans for a new fiscal compact to enforce greater budgetary discipline, European leaders remain unable to agree on how to put an end to the crisis and stimulate growth.
The eurozone has, according to the bank's Global Economic Year Ahead report for Europe, entered ï¿½a sort of limbo". And to get themselves out of it, Europe's leaders are facing a simple choice: to take ï¿½the deeper integration way, or the highway." We caught up with the bank's chief European economist and author of the report, Laurence Boone, to find out more.
ï¿½At the moment, we believe southern euro area countries are likely to post negative growth and therefore enter a recession in the first half of 2012,"ï¿½ says Laurence. The extent of economic difficulties will vary across the eurozone, with financial market stress, fiscal contraction and poor credit availability damping growth. But Laurence predicts that, in the short-term, European politicians will continue to ï¿½muddle through" as they did throughout 2011 rather than taking measures to boost economic growth and tackle unemployment. This approach, she says, will increase the risk that contagion will spread to the core of the eurozone.
Economists at the bank feel that if Europe's leaders fail to find a solution in the next few months, investor confidence will deteriorate further, worsening the situation of Italy and Spain. Laurence believes that in such circumstances, ï¿½the European Central Bank (ECB) would step in forcefully to control the situation, or we'll see a more decisive step by European policymakers towards fiscal integration."
ECB to the rescue
Until now, the ECB has been reluctant to intervene in the eurozone debt crisis on a large scale because its mandate is limited to keeping inflation low and because it's obliged to stay independent from politics. But, argues Laurence, a significant step was taken last December when the ECB decided to cut interest rates and fund Europe's banks with three-year fixed interest rate loans. This latter step, she explains, provides banks with valuable funds at a time when they're under pressure to build up their reserves of capital, which has limited their business activities. This cash injection will ï¿½facilitate banks funding, avoiding a liquidity crush".
Economists at Bank of America Merrill Lynch predict that the ECB will take further action if a dangerous deterioration of the situation seems imminent. Laurence lists frozen interbank lending markets, a loss of investor faith in eurozone sovereign (government) debt, or a worsening political outlook in Greece and the suspension of its bailout funds as potential trigger events. In any event, the bank expects the ECB to cut interest rates again in the first half of the year to stimulate economic activity and provide more liquidity to banks if needed, but to extend its programme of sovereign debt purchases to promote stability only if the situation deteriorates markedly.
Integration's the answer
The most promising solution to the economic crisis, says Laurence, would be fiscal integration across the eurozone. Fiscal integration would involve the creation of pan-European bonds to share and collectively guarantee the euro area's debt, and the establishment of a centralised body to control budgetary decisions across the 17 eurozone states would be a pre-requisite. Such a move, she says, would encourage investment in eurozone economies, so stimulating economic growth. There are problems, however, with this approach. European countries are reluctant to surrender control over their budgets, and Germany and other northern European economies are opposed to the idea of shouldering the burden of the debts of the weaker ones on the eurozone's periphery. What's more, amending EU treaties is a long and drawn out process, so might not provide a quick enough solution to keep the eurozone afloat in the short term.
A European ï¿½fiscal union" was on the agenda at the Brussels eurozone summit last December, but Laurence says the results of the discussions were ï¿½very modest" and that the proposals for fiscal discipline stop far short of the level of integration needed to lift the eurozone out of crisis. She explains: ï¿½What's missing for fiscal integration to be a viable solution is a financial commitment from the strong euro area countries to support their weaker partners in the single currency union." She adds: ï¿½European leaders need to decide whether they want fiscal integration, and if they're ready to support it and sell it to their people. If they don't want it, it's likely that the situation will remain unstable."
Make or break?
Whatever happens in 2012, one thing is for certain: Europe's leaders will be forced to make tough decisions about the area's economic and political future. Will the world's largest economic and monetary union survive? ï¿½I expect so," says Laurence with confidence. ï¿½I can't say how many members it will involve but, taking the long view, the current crisis should be seen as a stepping stone towards an EU superstate."