The eurozone island of stability

Marketvolatility has surged lately, apparently vindicating those who havewarned of lofty equity valuations. But, even as the US stock marketsuffered one of its worst weeks since the financial crisis, theeurozone’s public-debt market has remained relatively stable, with riskspreads – which have usually increased amid market volatility – scarcelychanging, even for the peripheral eurozone countries.The eurozoneowes its ostensible immunity from financial-market gyrations to majorimprovements in the peripheral economies’ fundamentals: growth haspicked up, and unemployment, though still high, is declining rapidly.The question is whether these improvements are stable enough to ensurethe eurozone’s continued resilience.Here, the key concern is thatthe current recovery is too dependent on low interest rates: ifborrowing costs rise, the periphery’s debtor countries would suffer. Butit is no longer accurate to view the economies of the periphery as weakdebtors. Indeed, with the exception of Greece, they are all now runningcurrent-account surpluses, meaning that far from depending on capitalinflows, they are repaying their foreign debt.And, yes, thisincludes Italy, which, despite its high public debt, is running acurrent-account surplus at the aggregate level. In the past, Italy’sexternal deficits and surpluses were of roughly similar size, meaningthat the country is not a net debtor. Because its net internationalinvestment position is balanced, a generalised interest-rate hike wouldnot necessarily be bad for the country. The government would face higherdebt-service costs, but citizens would earn more on their savings.Spainand Portugal, by contrast, would probably suffer, owing to theirstill-considerable external debts. Nonetheless, if interest-rate hikesare aligned with accelerating global growth, even these countries mightnot be much worse off, because growth will help them to service theirforeign debts.But the implications of today’s constellation ofcurrent-account balances extend beyond shorter-term interest-rateconsiderations. If the situation persists for a few more years, theeurozone might get to a point where it consists only of creditorcountries, some with a large net foreign asset position (Germany and theNetherlands) and others (the peripheral countries) with a smallpositive external position.This would have important politicalconsequences. For starters, the conflicts of interests within such aeurozone might be much less acute than those that emerged during thecrisis a decade ago, when creditor countries were obliged to bail outthe debtors, which in turn felt squeezed by forced austerity.Morebroadly, the relative power of the creditor countries – particularlyGermany – will be diminished. The concerns expressed by some observers,such as George Soros, that the eurozone will remain a two-tier club, inwhich the creditors impose their conditions on the debtors, thus seemexaggerated.But that does not mean that this new dynamic isrisk-free. If former debtors, facing diminished pressure from majorcreditors or risk premia, adopted less prudent fiscal policies, theirpublic debt would continue to accumulate. Against that background, thenext crisis might be very different from the last one.When the lasteurozone crisis began, large capital flows into the periphery weregenerating inflationary pressures; resources were shifting away fromexports; and government revenues appeared to be strong. Then the capitalinflows abruptly reversed, which demanded a decline in domestic wagesand prices, relative to the eurozone average, in order to shiftresources back toward exports. In most countries, government revenuesfell, as domestic activities, such as construction, contracted muchfaster than exports increased. As a result, the peripheral economiesfell into a deep recession.Making matters worse, because anexport-led recovery yields less revenue – value-added taxes are rebatedon exports, but collected on imports – seemingly strong governmentfinances quickly turned into large deficits. In Greece’s case, theproblem was compounded by the fact that, during the boom years, thelarge fiscal deficits had been financed entirely by capital inflows.When these flows stopped, the bottom fell out of public finances.Today,eurozone countries are not subject to large capital inflows, so acrisis would not cause them to face external disequilibrium. They wouldnot need a large downward adjustment in wages and prices, and governmentrevenues would remain relatively stable.If risk premia increase, itwould be a result of creditors’ doubts about a government’s ability tofinance itself in the long run, owing to a downward revision of growthexpectations or a domestic political stalemate in which taxpayers opposebondholders. Domestic bondholders might be the first to recognisepotential risks, spurring escalating capital flight.In thesecircumstances, a loan from the European Stability Mechanism – theeurozone’s bailout fund – would merely provide fuel for even higheroutflows. Yet transforming the ESM into a “European Monetary Fund” iscurrently one of the main issues in the debate about eurozone governancereforms. The implicit role model is the International Monetary Fund,which has made its reputation by addressing the fallout from suddencapital-flow reversals. Again, that is not the type of crisis thattoday’s less inflow-dependent eurozone is likely to experience.Insteadof trying to copy the IMF, Europe’s leaders should be focused onstrengthening the resilience of the financial system, so that it canprovide a safety valve for whatever pressures inevitably arise from thebuild-up of excessive public debt in some eurozone countries. If acrisis does occur, the ESM’s resources could perhaps be used to preventcontagion within the eurozone financial system, rather than to provideloans to countries with deep-seated domestic problems.After a decadeof struggles, the eurozone is an island of relative stability in aturbulent sea. To ensure that it stays that way, its leaders mustremember a fundamental truth: no predominantly domestic problem willever be resolved by a loan or transfer of resources from abroad. –Project Syndicate* Daniel Gros is Director of the Center for European Policy Studies.