13 November 2012

Douglas J Elliott: Europe could still blow up, let's not be complacent

European leaders are clearly making real progress in working through the euro crisis. However, some observers have lapsed into complacency, assuming that the worst is definitely over. But there are many ways in which the situation could blow up and become worse than ever.

The bad news comes in two flavours: European and national. At the European level, one of the biggest concerns is that the banking union has been overhyped. It's clearly a positive development that could be a great help in the long run. It is much less certain how useful it will be in the critical next year of the crisis. Full banking union involves: agreement on common rules across the eurozone; common application of those rules by bank supervisors; a common deposit insurance fund; and a common approach and communal funds to restructure or liquidate failing banks. Europe is, with some difficulty, finding agreement on common bank regulation and supervision. This is good, but will show benefits only in the longer run. The more immediate issues are about resolving troubled banks in the weak countries and supporting their deposit insurance schemes in order to avoid bank runs. Those portions of banking union are subject to more dispute, primarily because they directly involve money, and have been pushed off until consensus can eventually be found.

Worse, there remain a host of national hot spots that could turn into raging fires. Greece is the most obvious. The coalition government is tenuous and it is very possible that it could fall when pushed further towards the necessary steps to implement reforms. On the other side, political constraints in other nations in Europe may result in unreasonable demands on Greece that would trigger a breakdown in negotiations and the possibility of true disaster. Such a disaster could propagate throughout the eurozone if it led to a disorderly withdrawal of Greece from the euro, since this would raise risks that other troubled countries might be forced into similar moves. The eurozone has not yet built enough protections to ensure that it could handle the collapse of Greece.

The problems extend well beyond Greece. Ireland and Portugal are viewed as "good students" who are implementing the changes demanded by the eurozone leaders. However, their economies have serious structural problems, including annual budget deficits that are about 10 per cent of GDP in the case of Ireland. There is no guarantee that these nations will avoid having to restructure their debt, potentially setting off other problems in Europe.

Spain and Italy, as is well known, also have their scary aspects. The economic problems in Spain are vast, even though national debt levels are below those of many countries. In Italy, the biggest risk is political, since the system has not functioned well for years and is in the midst of a chaotic transition, with a new populist party gaining substantial support. Italy's economy has many strengths, and the country is a wealthy one, but it has high levels of national debt as a legacy of bad management years ago. High debt means that a loss of confidence in the political system could lead to real funding problems and even a debt restructuring.

In short, it's great that Europe is making progress and I continue to believe that it will muddle through. But, we have to keep in mind that there remains a substantial probability of disaster.

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