This piece was written on the 14th of September and appeared as an Op-Ed in the Wall Street Journal on the 20th of September
Markets have been euphoric about the recent good news in the euro zone: the European Central Bank’s promise of potentially unlimited bond purchases, the announcement of a banking union, Germany’s green light for the European Stability Mechanism (ESM), a pro-European result in the Dutch election, and a softer EU stance on Greece.
All of this is in marked contrast to the fears of a summer meltdown that never quite happened. Could this be the beginning of the end of the euro zone’s crisis?
Unfortunately, the answer is “probably not.” The crisis has been allowed to fester so long that the economic problem may now be too big to be addressed within the shrinking political space available.
To emerge once and for all from the euro crisis, three things would be essential: stronger intervention by the ECB to limit possible short-term damage, credible economic growth strategies for crisis-hit countries, and a longer-term plan that provides for macroeconomic adjustment and reforms to the functioning of the euro zone. Europe has one-and-a-half out of three at best.
The ECB has come out fighting, but it has tied one hand behind its back by making its interventions conditional. It may also be acting too late. Political developments over the past several months have made it impossible—even irresponsible—for investors, savers, consumers, businesses, banks and regulators not to take into account the possibility of a euro-zone breakup. That way lie ongoing capital and deposit flight, postponement of investments, and the reorientation of assets and liabilities along national lines. All of these actions are individually sensible but collectively disastrous for the euro zone.
Any decision on a Greek exit or a larger breakup would be political and therefore out of the ECB’s control. Nor could the central bank credibly contain large-scale capital or deposit flight if these continue. If market sentiment deteriorates again, the ECB’s unlimited “outright monetary transactions” could end up merely financing capital flight, as happened with its limited “securities markets program,” in which the central bank ended up buying bonds from investors looking for an exit.
Likewise, suppose that a German bank were to aggressively market the safety of Germany’s deposit-guarantee scheme to Spaniards through a local branch in Spain. The ECB could do little to stem the flight of deposits that would result.
So while the central bank’s conditions on its support for Spain and Italy are understandable given the political context, a conditional floor is not a wholly credible floor.
Perhaps the euro zone’s biggest problem will arise from the strict fiscal conditions imposed in exchange for ESM and ECB support. The benefits of lower borrowing costs are rather limited when one is not allowed to borrow. The growth picture in the euro zone, particularly in the crisis-hit countries, has seldom looked worse. The so-called “growth compact,” adopted by EU leaders with such hullabaloo, has proved insignificant. And to the extent that ECB and ESM conditionality imposes additional fiscal austerity, it will only cast a dark shadow on near-term growth, raise unemployment beyond already record-high levels, increase indebtedness as a percentage of GDP, and foment social unrest.
Particularly troubling is the speed and size of the potential impact that shrinking nominal GDP and rising unemployment can have on the housing market in Spain. Every percentage point of GDP reduction in public spending could translate to significant additional losses in the wider economy, given the sensitivity of asset prices to economic growth and future prospects.
As for the agreement to directly inject ESM equity into Spanish banks there is less here than meets the eye. The burdens of Spanish banking losses are still set to fall mostly on the Spanish sovereign, including any losses incurred between now and whenever the ESM is ready to inject equity. There is no plan yet to put equity into Spain’s so-called “bad bank,” where a majority of future losses may materialize. Some countries are even calling on Spain to indemnify the ESM against any losses on its equity—a contradiction in terms.
The other element of Europe’s banking-union discussions that might have helped with the crisis today, a euro-zone deposit-guarantee scheme, has now been rejected entirely. If depositors in Spain panic, the cupboard will be nearly empty.
Policy makers’ inability to remove a euro-zone break-up from the realm of possibility, and the absence of any credible growth plans, mean that economic actors will continue to be motivated by fear more than greed or hope. In all likelihood the situation will continue to get worse before it gets better, if it gets better at all.
Mr. Goodhart is professor emeritus of banking and finance at the London School of Economics. Mr. Kapoor is managing director of Re-Define, a European think tank.