The Eurozone entered 2014 in its best shape in four years, boosting hopes that its crisis years are finally over. Andreas Höfert analyzes the challenges and structural problems faced by the region, and why we can be cautiously optimistic about its fragile recovery.
Chief Economist, Chief Investment Office, UBS Wealth Management
In a tale of two states, one has an economy five times the size of the other’s. Its GDP per capita is 70% higher, and its poverty rate at nearly 7% is well below the other’s 20%. Yet, New Jersey and Mississippi share the same currency and no one questions why they should.
In a tale of two cantons, one speaks German, is urbanized, and has a long Protestant tradition. The other speaks French, is rural, and has an even longer Catholic tradition. Yet again, Zurich and Valais share the same currency and no one questions why they should.
So why are the United States and Switzerland optimal currency areas despite their economic and cultural diversity, but not the Eurozone? Like many other countries, the United States and Switzerland have institutions that allow their vastly diverse regions to share a common currency. These institutions go well beyond a central banking authority and they are, unfortunately, absent in the Eurozone.
The makings of a healthy union
When the euro was created more than 15 years ago, one main argument of the leaders of the European Union (EU) was that the introduction of a common currency would naturally result in the establishment of such institutions. This promise, however, was never followed through during the first 10 years of the euro’s existence. Now, it needs to be fulfilled in the midst of a crisis that was caused by the absence of these same institutions. So what exactly are they?
First, sharing the same currency means the disequilibria or disparities between the different parts of the union cannot be corrected through the exchange-rate mechanism. The value of the currency of a country in surplus cannot be raised, just as the currency of a country in deficit cannot be devalued. Therefore, in a currency union, these disequilibria tend to persist or even worsen unless there is some form of transfer from the rich regions to the poor. This means that for a currency area to work, it needs some kind of fiscal coordination – one that is much deeper than what is currently in place in the Eurozone.
Second, while regions within an optimal currency area may differ economically or culturally, these differences must not be exacerbated by having different social and labor-market laws that make it systematically more expensive to produce in one region than in another. For example, if I’m setting up a factory, my non-wage labor costs would be the same whether I’m located in Rochester, New York or Shreveport, Louisiana. However, as these costs are different in Rotterdam and Marseilles, they would affect my decision on where to build my factory. In other words, a currency union cannot work in the long run if workers in one member country can retire at the age of 55, and those in another, at 70.
Third, a currency union cannot work in the long run if the financial intermediaries operating in the union abide by different sets of rules – if the way they are regulated, controlled, and, should they run into trouble, saved, varies according to the specific laws of each country. In a union where such regulatory variances exist, the banks from countries with more relaxed regulations lack a comparative advantage, which may lead them to take disproportionate risks with consequences that are ultimately borne by the central bank.
Therefore, for a monetary union to work in the long run, not only does it need the presence of a central bank, but also a form of fiscal, social, and banking union. Looking at Europe in the 15 years since the introduction of the euro, we find it nowhere near being an ideal monetary union.
“The Eurozone faces a risk of deflation – a risk the ECB is taking seriously.”
A union in healing…
Having said that, the Eurozone entered 2014 in its best shape in four years due to four major improvements: growth came to light, imbalances were reduced,formed. This banking union may, in fact, be created by the end of the year.
After almost two years in recession (the second recession since the global financial crisis erupted in 2007), the Eurozone finally grew in the fourth quarter of 2013. Even better, all four of its largest economies – Germany, France, Italy, and Spain – were back in positive territory. For full-year 2014, we expect the Eurozone to pull off a growth rate slightly north of 1%. While this still makes it the weakest region in the global economy, at least its growth rate is positive at last.
The second piece of good news is that some of the large imbalances the euro had created have receded quite significantly since the beginning of the crisis. To take one striking example, Spain has managed to keep its trade and current-account balances at equilibrium for the last 18 months – the first time it has been able to do so since the introduction of the euro. The root cause of this improvement is falling unit labor costs, which have also been observed in Greece, Ireland, and Portugal, and is also becoming evident in Italy. The European periphery is becoming more competitive again, with France the only country currently lagging.
The third welcome development is how interest rates in the European periphery have moved over the last two months. Interest rates on 10-year Spanish and Italian government bonds are now close to 3.5%, almost half of where they were at the height of the euro crisis two-and-a-half years ago. Even Portugal, which we had considered just three months ago as being in need of a new help package, may be able to come back to the market by the end of the year if – and this is a big ‘if’ – interest rates stay where they are. Such an event would really be a European success story.
Finally, bright prospects point to some form of banking union being in place by the end of 2014 – one with a single set of rules, a single supervisor through the European Central Bank (ECB), and even a single resolution mechanism in the event of trouble. Such a banking union is paramount to ensuring the turnaround of the still-falling credit activity in the Eurozone, which, if allowed to continue, would jeopardize the region’s growth prospect.
All these good news have led us to take a more positive view on equities in the Eurozone, where we particularly like cyclical and financial companies.
“Bright prospects point to some form of banking union being in place by the end of 2014 – one with a single set of rules, a single supervisor through the European Central Bank, and even a single resolution mechanism in the event of trouble.”
…yet a union at risk
Patient Eurozone seems to be out of intensive care now, recuperating. However, it remains in hospital and is at risk of experiencing a relapse. The most significant risk comes from the flip side of the European periphery’s regained competitiveness. The reason unit labor costs have fallen in these countries is that wages have declined, which in turn has been a consequence of massive unemployment. These falling wages have also started to put downward pressure on prices, to the extent that the Eurozone now faces a risk of deflation – a risk the ECB is taking seriously and will continue to monitor attentively.
Why is deflation such a bad thing in this environment? Because, combined with still-falling credit activity and dismal demographic prospects, it reminds us of Japan in the 1990s, with one caveat. Unlike the Japanese, Europeans lack the virtue of patience to endure economic hardship. This leads us to the second major risk in our outlook: political risk.
Nearly five years into the euro crisis, Europeans are weary and have developed a tendency to vent their frustration in the streets and in polling booths. This spring, from 22–25 May, citizens of all EU member countries will elect a new parliament. According to recent polls, ‘traditional’ political parties may suffer heavy losses to anti-EU parties from the extreme right or left in the political spectrum. We can imagine these parties occupying up to one-quarter of the European parliament, and hesitate to imagine the consequences on national politics and efforts to solve the euro crisis.
The euro was never an economic project but a political one. Without the assurance of political will toward deeper integration, most economists, if they had been asked if a single currency was economically feasible in Europe, would have answered with an emphatic “No.”
While steps have finally been taken to address some of the Eurozone’s most important issues, the region is still eons away from resolving its crisis. However, on a six-month horizon, and considering what has been achieved so far, we remain confident of the Eurozone and its equities.