05 January 2014

Wolfgang Münchau: What euro crisis watchers should look for in 2014

The euro crisis is not over, but one important shift has taken place. The policy debate has concluded. The decision not to set up a common backstop for the eurozone’s banks has closed the last window for any form of debt mutualisation as a tool of crisis resolution. All of the adjustment will take place through austerity and price deflation in the periphery. Most of the adjustment still lies ahead. Furthermore, it has been decided that debt burdens will be reduced by paying them off – not by inflation, default or debt forgiveness.

If you look at this with a knowledge of economic history, this is an awe-inspiring set of choices, to put it mildly. The only policy innovations to soften the harshness are two existing backstops: the European Central Bank’s as yet untested Outright Monetary Transactions (OMT) programme, through which it can buy the debt of troubled states; and the European Stability Mechanism (ESM).

The end of the euro policy debate naturally shifts the focus of interest. What matters now is the adjustment itself, and the sturdiness of the OMT. In the first half of 2014, keep an eye on three events with a bearing on these questions: a forthcoming ruling on the OMT by the German constitutional court; decisions by the Italian government; and the elections to the European Parliament.

The German constitutional court may, or may not, demolish the credibility of the OMT programme. It is an odd case because the court has technically no jurisdiction over the ECB. But it could, for example, demand that the German government, parliament or central bank – over which bodies it does have jurisdiction – act in such a way as to stop the implementation of this programme in practice. Or it might impose other restrictions that would have a similar effect...

Looking to the second event, Italy’s importance to the future of the eurozone can hardly be overstated. With no prospect of any form of debt mutualisation, Italy has only one single course of action left if it wants to prosper in the eurozone. Its economy must become like Germany’s. I doubt that is feasible, but this is the choice successive Italian governments have made and is the choice that determines the reform agenda...

The third event is the European Parliament election in May. This will give us some indication of whether the political support for this type of adjustment enjoys continued political support in Italy and other periphery countries. Hordes of anti-European parties are preparing to march on the gates of Brussels. Together, they could gain up to one-third of all votes. The problem is not only their combined voting power but also their impact on the leading centre-right parties, which are becoming more eurosceptic as well.

Notably absent from my list is the ECB’s asset quality review of the banking sector. The reason I no longer take a big interest in this exercise is the way the policy debate has concluded: the pitiful remnants of Banking Union matter to the institutions affected and to the bureaucrats with shiny new jobs in supervision – but, in the absence of a common backstop for failing banks, not to the economy.

This is the year when the emphasis shifts from the policy choices to their consequences. The eurozone’s leaders have settled on an adjustment strategy of a historically unprecedented scale, flanked by a backstop whose main construction element consists of fairy dust. By the end of the year, we will have a clearer idea of whether that set of choices is feasible.

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