Europe: the final countdown

Finbarr Bermingham hears from two economists at Nomura about prospects for Europe's troubled economies

In a speech at Zurich University in 1946, Winston Churchill outlined the need to "recreate the European Family", and called for "a United States of Europe". Sixty-five years on, the continent's integration runs deep, but the EU is experiencing its most challenging economic period since Churchill spoke. The euro is in crisis, unravelling like a cheap jumper. Every morning, the news reports a fresh "catastrophe", and the Eurosceptics are sharpening their knives. Stella Wang, European Economist at Nomura, cuts right to the crux of the problems currently facing the region.

"Activity in the euro-area economy has clearly been losing momentum, reflecting the drag on consumer spending from high oil prices, weaker external demand, and negative confidence effects from the ongoing sovereign debt crisis. Debt levels are high, and consumer and business confidence have collapsed. It's a bad situation. The next year will be tough, but we don't think the euro will break up."

Speculation about the future of the single currency has been intense, with many predicting its demise as the nations in which it is used suffer economically. Greece in particular has hogged the headlines as it struggles to meet the conditions it was given on receipt of successive bailouts from the International Monetary Fund (IMF) and European Union (EU). In truth, though, the problems are far more widespread. Ireland and Portugal have been the subject of financial packages, too, and there is mounting speculation that Spain and Italy - significantly larger economies - could be next in line. Lavinia Santovetti, Vice President and European Economist at Nomura, while ascribing only a 5 per cent chance to the euro dissolving, calls for greater fiscal unity across the eurozone, and warns that further stimulus packages may be required.

"The financing packages have been successful but it's a very long process of recovery. There's a chance that Ireland and Portugal may require second packages. Greece will certainly need more assistance, since it's becoming weaker. The big question is: what's going to happen if countries as big as Spain or Italy need assistance? It has been agreed that the European Financial Stability Facility (EFSF) can buy bonds on the secondary market, which may help, but the EFSF alone is not big enough to support, or bail out, these countries. The EFSF needs to be strengthened by the EU and to have more ability to act quickly and decisively." As well as macro level reform, Lavinia thinks structural review within individual countries is key, too. "These nations need to implement proper reforms, such as reforms to their the labour markets, or liberalisation of some sectors in which competition is not strong enough, like tourism."

For citizens of the aforementioned countries, calls for further spending cuts and more privatisation are unlikely to prove popular. Lavinia admits the measures proposed are tough, and that the benefits are mainly long term. "It will take a while before you see the fruits of these reforms," she says, "but there's no other way out. Without them, governments will end up paying more for their debt. Rebalancing the economy is absolutely crucial in order to restore growth. In the short term, it'll be painful, but in the long term, through reduced debt repayments, the reforms should free up government funds for public spending."

To a fault

The word "default" has rarely been far from the headlines this year and despite the billions that have been pumped into the floundering euro states, it isn't going to disappear any time soon. Nomura economists think the most likely scenario (which they've given a 55 per cent probability of occurring) is the one they've termed the "relatively benign outcome". This would entail austerity bills being passed in the Greek parliament, triggering around €60 billion of additional funding by the EU and IMF. The debts accrued by Greece to other creditors would be rolled over and guaranteed by the EFSF, equating to what is, in essence, a managed default. Both economists are at pains to stress how important it is that such an event is orderly and that the destabilising effects on the region are minimal.

"An unmanaged default would be a disaster," says Lavinia. "The impact on financial markets would be massive, which would filter down into the real economy. It would be like the Lehman Brothers effect, but on a national level. Economies are so interlinked through financial markets that this could cause a global recession."

Stella agrees, and assesses the possible implications on the UK's economy a credit event like an unmanaged Greek default would have. "The UK is not that highly exposed to Greece's sovereign debt," she says, "but the situation is different with Ireland. If things get out of control and contagion spreads to Ireland, the British banking sector will be hit very hard. Market confidence will suffer, which in turn will hinder investment by businesses. There will be a large impact on recruitment from which the job markets would be slow to recover. For students, this would be bad news. It would affect almost all graduates."

Bonding

With policymakers scrambling for solutions to the debt crisis, there have been calls from some quarters (perhaps most notably, from European Commission President José Manuel Barroso, who has described them as the "master solution") for the issuance of EU-wide bonds. The idea behind these is that the 17 countries of the eurozone would guarantee each other's debts in the form of common bonds, meaning each government could borrow at the same rate and same cost. Stella, though, says that the proposal has some problems.

"Euro bonds would be issued to help the countries with funding problems," she explains. "The low-grade debt would be underwritten by Germany, France and the Netherlands. But this would affect the overall ratings of the bonds and is similar to taxing the northern euro nations without restructuring the southern ones. Without reforms in the southern economies, we're back to square one!"

The road to resolution will be rocky; but not, say Lavinia and Stella, impassable. The spirit of Churchill's vision of European unity must be evoked if the continent is to steer itself clear of this crisis but be warned, this one will rumble on for some time yet.

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