Investors are missing the real risk: the collapse of public support for, or at least public acquiescence to, the austerity policies required to work down heavy debt burdens
Is Europe's crisis over? Investors, policy analysts, and even officials are quietly beginning to suggest that this might be the case. The euro has strengthened by nearly 10% against the dollar since European Central Bank president Mario Draghi vowed on 26 July to do "whatever it takes" to hold the currency together.
Similarly, the Euro VIX, a popular measure of expectations of euro volatility, has fallen significantly. The cost of buying protection against fluctuations in the euro/dollar exchange rate declined last month to its lowest level in nearly five years. Borrowing costs for the Spanish and Italian governments have similarly fallen dramatically.
A consistent narrative underpins this change in market conditions. European leaders have put in place mechanisms to support Italy and Spain. As of October, the continent has an operational European Stability Mechanism to purchase new Italian and Spanish government bonds if investors go on strike.
In parallel, the ECB has announced an "outright monetary transactions" (OMT) programme to purchase bonds already trading on the secondary market. At their most recent summit, European Union leaders reiterated their commitment to finalize the design of a single supervisory mechanism by 1 January 2013, and to activate it by the end of next year.
These steps, it is argued, have taken both sovereign-default risk and a banking crisis off the table. With the ESM and ECB capping interest rates on government bonds, countries will have as much time as they need – and they will need plenty – to reduce their debt burdens to manageable levels. And, with a single supervisor in place, the ESM will be permitted to inject capital directly into troubled banks. The new banking union can then be extended to include a common resolution fund to enable the orderly dissolution of insolvent institutions.
To be sure, there are some gaps in this narrative. The ESM has limited firepower, and, along with the ECB, will buy only the bonds of governments that ask, something that proud leaders are reluctant to do. The end-2013 deadline for implementation of the banking union is a long way off. Even if there is agreement on the need for a common resolution fund – which is not clear – there is no agreement on how to pay for it.
Nevertheless, the markets evidently regard this as a comforting bedtime story – all the more so now that European leaders have averred that Greece will not be pushed out of the eurozone. Officials recognise that cutting off EU support and compelling the ECB to stop providing credit to the Bank of Greece would be Europe's Lehman Brothers moment. The consequences could be catastrophic, not just for Greece, but also for Portugal, Spain, Italy, and who knows whom else.
In their 18 October communique, eurozone leaders stated in no uncertain terms that they are not prepared to go there. Given Europe's facility at creative accounting, some way will be found to keep Greece on life support.
So, is the crisis really over? In focusing on summit declarations and promises of far-reaching reforms of EU institutions, investors are missing the real risk: the collapse of public support for, or at least public acquiescence to, the austerity policies required to work down heavy debt burdens – and for the governments pursuing these policies. Mass anti-austerity protests are one warning sign. Another is growing popular support for neo-Nazi movements like Golden Dawn, now the third-largest political party in Greece.
The rise to power of a "rejectionist" European government – that is, one that unilaterally rejects the policy status quo – would immediately bring the crisis to a head. A Greek government that summarily rejected conditions set by the EU and the International Monetary Fund would immediately be cut off by the ECB and forced to exit the euro. A Spanish government that did likewise would lose all prospect of support from the ECB's OMT programme, and the markets would quickly pounce.
Some will object that dire warnings of political reaction are overdrawn. So far, no country has voted into power a rejectionist administration. Even in Greece, where conditions are the worst, Golden Dawn is still a minority party. The answer to these critics is, unfortunately, "just wait". It is worth recalling that nearly four years passed from the onset of the Great Depression in Germany to the Nazis' accession to power.
Europe needs a growth strategy to put this political genie back in the bottle. It needs policies that hold out the promise of lower unemployment and better times. The continuing absence of such policies is the gravest threat to the euro. Unless that changes, markets will wake up to that risk – perhaps with a jolt – sooner or later.
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