The Future of the Eurozone: Outlook and Lessons

The above title is the topic of a hearing recently held (last August 1) in the United States Senate Committee on Foreign Relations.

It should be of no surprise to anyone that the present tumult in the Eurozone has the interest of the US Senate. An eventual collapse of the Euro will generate economic shockwaves that will affect the United States economy signicantly seeing the transatlantic bond is the most integrated commercial artery in the world. One of the experts giving his view on the topic was Simon Johnson - professor at MIT's Sloan School of Managment and a former director at the IMF.

For over two years Europe’s political leaders have promised to do whatever it takes to save the euro area. Yet problems are growing and solutions still seem far off. The October 27 and December 9, 2011 agreements of European leaders failed to change the dangerous trends in Europe’s economies or markets. The implicit risk of default priced in sovereign bond markets reached all-time highs in the last three months. The trend is similar with bank default risk. The crisis is continuing to get deeper, broader, and more dangerous.

A combination of misdiagnosis, lack of political will, and dysfunctional politics across 17 nations have all contributed to the failure so far to stem Europe’s growing crisis. Johnson's testimony began with a view on the main problems that are pushing the euro area towards collapse. He then turned to potential solutions (although he is very aware that the complexity of the problems in Europe renders any solution questionable), and finally he outlines several factors that could trigger rapid financial collapse in the euro area.

It makes interesting reading.  Johnson's full testimony can be read here. Below is a summary: 

1.  Successive plans to restore confidence in the euro area have failed. The market cost of borrowing is at unsustainable levels for euro banks and a significant number of governments.

2.  Two major problems loom over the euro area. First, the introduction of sovereign credit risk has made nations and subsequently banks effectively insolvent unless they receive large-scale bailouts. Second, the ensuing credit crunch has exacerbated difficulties in the real economy, causing Europe's periphery to plunge into recession. This has increased the financing needs of troubled nations well into the future.

3.  With governments reaching their presumed debt limits, the European Central Bank (ECB) is now treading a dangerous path. It feels compelled to provide adequate "liquidity" to avert systemic financial collapse, yet must presumably limit its activities in order to prevent a loss of confidence in the euro—i.e., a change in market and political sentiment that could lead to a rapid breakup of the euro area.

4.  Five measures are needed to enable the euro area to survive: (1) an immediate program to deal with excessive sovereign debt, (2) far more aggressive plans to reduce budget deficits and make peripheral nations "hypercompetitive" in the near future, (3) supportive monetary policy from the ECB, (4) the introduction of mechanisms that credibly achieve medium-term fiscal sustainability, and institutional change that reduces the scope for excessive leverage and consequent instability in the financial sector.

5.  Europe's leaders have mainly focused on a potential long-term fiscal agreement, and the ECB under Mario Draghi is setting a more relaxed credit policy; however, the other elements are essentially ignored.

Johnson is of the opinion that this crisis is unique due to its size and the need to coordinate 17 disparate nations. In his testimony he suggests four examples of economic, social, and political events that could lead to more sovereign defaults and serious danger of systemic collapse. Each trigger has some risk of occurring in the next weeks, months, or years, and these risks will not disappear quickly.