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Soko Tanaka

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Quieting down of the euro crisis and future issues

Soko Tanaka
Professor of International Finance and European Economy, Faculty of Economics, Chuo University

1.Foreword

The volatile Euro crisis continued from the second half of 2011 until the dangerous situation of Greece possibly leaving the Euro Area in the spring and summer of 2012. However, July 2012 saw the quieting down of the crisis. The tranquility continues today, with the Euro, which fell to the mid-90 yen zone last January, rising back to 123 yen in January this year. I would like to comment on the reasons for that and the future of the euro crisis.

2.A new tack from the ECB (European Central Bank)

At the end of July 2012, ECB (European Central Bank) President Mario Draghi declared, "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro." The impact was so strong that European and American investors acknowledged that "2012 will be remembered for just three words: "whatever it takes." The ECB, under the Managed Currency System, possesses the ability to inject unlimited amounts of cash. Investors and financial markets took President Draghi's statement to mean that the ECB would play the role of lender of last resort.

It could be said that the central bank's purchasing of government bonds at the time of the financial crisis in order to provide financial stability was self-explanatory, however that type of ECB competence is not specified in the Treaties of the European Union. It can be interpreted that the job of the ECB is to protect price stability, and not to interfere in other matters.

However, when the August 2007 subprime crisis blew up in the EU, the ECB injected an enormous amount of liquidity into banks equating to 20 trillion yen a day, and acted, in a classical sense, as lender of last resort. Furthermore, when the Greek crisis erupted in May 2010, it bought into the Greek bonds on the secondary market, mobilizing as the 21st century type of the lender of last resort, or to be more precise, the buyer of last resort.

However, the inflation-wary and stubborn Deutsche Bundesbank did not agree with this action. The then president of the DBB was due to be the next president of the ECB, but, fortunately, he resigned from the DBB and took up a post at a major Swiss bank, and Mario Draghi of Italy was chosen to be the next ECB president. President Draghi was an active member in the Italian Ministry of Finance (equivalent to the Ministry of Finance in Japan) and the Bank of Italy, as well as having experience in working for American investment bank Goldman Sachs. He was just the person for the position of president in a time of crisis.

From December 2011 to February the following year, the ECB twice injected funds into banks totaling 1 trillion euro (about 100 trillion yen). Sufficient funds were extended to over 800 banks, abruptly ending the raging bank and financial crisis. It was called the Draghi Magic.

On top of the speech of Mr. Draghi of July 26, at the September 6, 2012 ECB Governing Council, President Draghi overcame DBB President Jens Weidmann's opposition, and decided upon unlimited purchases of government bonds from troubled euro zone nations (short-term bonds with a current maturity of three years or less.) This is called the OMT (Outright Monetary Transaction.)

Financial markets staved off the attack and with this, saw the collapse of the euro tail risk disappear and stabilize. The German government's tacit approval of the decision was also reassuring.

3.Start of the ESM (European Stability Mechanism)

The ESM, ranked by the euro zone nations as a trump card for euro stability, received a constitutional ruling by the Federal Constitutional Court of Germany, and started up on October 8.

The ESM holds 80 billion euro in paid-up capital and guaranteed 620 billion euro in committed callable capital. Able to issue Triple A-graded bonds, it has a lending capacity of up to 500 billion euro. It also possesses the rights to purchase government bonds of troubled nations at the issuance stage, or directly inject capital without going through participating governments in order to prevent bank crises. The start of the ESM has also strengthened a sense of security in financial markets.

4.Reform of the euro system

At the European Council held at the end of June 2012 it was affirmed that it is imperative to break the vicious circle between banking crisis and sovereign crisis, and approved the establishment of a banking union. This can be said to be a landmark moment.

Because the euro crisis started with lax fiscal policies in Greece, the German government and others demanded that the euro crisis be taken as a sovereign debt crisis originating from irresponsible political actions in southern European countries, and punitive austerity budgets for governments of crisis-affected countries. However, when observed more analytically, it was financial markets that escalated the explosive situation. The root of that lies with the large-scale development of financial integration in cross-border markets by western European big banks after the introduction of the euro. Disparity continued due to western European banks marching into southern European countries and conducting large-scale lending and international investment, allowing for easy financing of budget and current account deficits in the South European countries until financing of the banks was reversed by the Lehman Shock.

The epoch-making nature of the above mentioned June European Council can be seen in that it was the first time the euro zone governments put overcoming the banking crisis in a position of the most importance. The banking union holds three functions as a single regulatory system giving federal supervisory authority over banks to the ECB, a common bank deposit system, and bank crisis solution mechanism (in charge of capital injection, relief and bankruptcy management.)

President Herman Van Rompuy (full-time President of the European Council), in a report presented to the Council, proposed the establishment of an integrated frameworks to preside over financial, political and economic policies alongside the banking union in order to create a genuine economic and monetary union.

In this way, with progress toward the realization of the ECB's lender of last resort function, the establishment of the ESM, and the establishment of the banking union and related frameworks, the combination of these three saw the quieting down of the euro crisis.

5.Dividing and restoration of euro zone financial markets

From spring 2012 until the Greek exit crisis that spanned the summer, the main players in the euro crisis were banks and financial markets. Because deposits flowed out of the troubled nations and went into stable markets such as Germany, in stark contrast to German 10 year government bonds which had yields of under 2%, bonds in the countries such as Spain and Italy rose to 6% or 7%, business and household loan interest rates also increased, and banks in southern European countries faced financing difficulties in interbank markets. Financial markets in the euro zone had been divided into north and south.

With the above reasons, the euro crisis calmed down, American external private debt shrank, housing prices stopped falling, and the economy also rallied. There was also a bottoming-out of economic growth in China, and an optimistic outlook for the future of the world economy spread. Even in the euro zone, the rise of Greek stocks has accelerated since last November, and foreign investors have been returning to southern European countries such as Spain. This January, American investors resumed large-scale investments in southern Europe. Yields on 10 year government bonds in Spain and Italy have dropped from the 4% zone to the 5% zone. The euro market has also recovered.

In this way, the euro crisis seems like a distant dream.

6.Mid-long term issues

With the inception of the euro, the point as to whether the gap between industrial and competitive strength of the countries in the euro area will close, or core nations will accumulate more and the industries of the peripheral nations hollow out, was a point of controversy from before the introduction of the euro. In reality, western European countries like Germany have increased competitiveness with low inflation rate bases, and southern European countries have lost competitiveness on the back of high inflation rates and consumer and real estate booms. The gap between current account surpluses in western European countries and current account deficits in southern European countries has widened in a mirroring image. However, deficits were financed with credit from the above mentioned western European banks, ultimately ballooning the bubbles which burst.

Although the current account surpluses in northern European countries and deficits in southern European countries have shrunk, they still continue on quite a scale. The predominance of northern production and competitiveness has reduced due to pay cut and rationalization of enterprise in the troubled southern European countries, but not enough to bring balance to the situation.

In order to reduce government debt in heavily indebted southern nations, nominal growth rates must be increased. If northern Europe expands government spending to stimulate the economy, it will prop up the recovery of southern European countries, but it appears that balanced budget targeting countries in the north, starting with Germany, have no intentions to do so.

If that is the case, euro-scale federal fiscal and industrial policies, such as spending of surplus nations going directly into deficit nations to strengthen industry in those countries and solidify the movement toward equality, are required on a euro area scale. In Greece, where government debt is expected to reach 190% in 2013, special measures must be conceived.

7.Conclusion

The euro zone, in order to prevent a recurrence of the banking and financial crisis, has to set a swift completion of the banking union as a necessary condition. On top of that, treatment of mid-long term finances must be prepared. The quieting down of the euro crisis serves as a temporary relief, but in order to maintain that, steps must be taken. 2013, in the same way as is for Japan, is a crucial year for the euro area. If we drop our guard through the temporary break in the crisis, the future will be perilous.

Soko Tanaka
Professor of International Finance and European Economy, Faculty of Economics, Chuo University
Born in 1945. Graduated from the School of Engineering, Kyushu University in 1967 and the School of Economics, Kyushu University in 1969. Completed the Master's program in Economics at the Graduate School of Economics, Kyushu University in 1971; then, worked as an assistant in the School of Economics at Kyushu University. Appointed as Professor of Economics, Tohoku University in 1986, Professor of Economics, Department of Economics, Hitotsubashi University in 2002 (concurrently), and to his current post in 2004. Doctor (Economics). Specializes in International Finance, EU Economy, and Economic Integration. Major publications include Modern International Finance [Gendai Kokusai Kin-yu] (co-editor and co-author: Yuhikaku Publishing, 2008), Global Economy, Financial Crisis and Europe [Sekai Keizai / Kin-yu Kiki to Yoroppa] (editor and author: Keiso Shobo, 2010) Euro-Unified Currency in the Crisis [Yuro Kiki no Naka no Toitsu Tsuka] (mentioned above),.
Modern European Economics (3rd Edition)[Gendai Yooroppa Keizai ](Tanaka, Et al. authors:Yuhikaku Alma, 2011), Economics of Monetary Union[Tsuuka Doumei no Keizaigaku - Yuuro no Riron to Genjou Bunseki] (Paul De Grauwe, translated by Tanaka and Yamaguchi: Keiso Shobo, 2011). and many others