Containing Contagion in the Euro Zone

For more than a year, the future of the euro, the ultimate symbol of European integration, appeared anything but certain. The euro zone has been shaken by cascading sovereign-debt crises. First, Greece required an emergency European Union-backed bailout in May, then Ireland followed in November, and on April 6, Portugal, long considered the next domino, finally asked for a rescue. Meanwhile, Europe’s squabbling leaders, pursuing national interests over those of the whole zone, failed to take the drastic action many thought necessary to halt the chaos. As one nation after another came begging for relief, the dream of a Europe in which pain is shared and mutual assistance is guaranteed seemed to slip out of reach.

Yet something unexpected, even miraculous, has happened. For now, the contagion that had raged across Europe seems to have ceased. Even as Portugal negotiates the painful terms of its bailout, the government bonds of Spain, thought to be the next nation at risk, stabilized. The value of the euro itself has shown remarkable resilience. In the wake of the Greek crisis, economists predicted the euro would fall against the U.S. dollar; but it has strengthened by 20% since the lows reached after the bailout.

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What turned things around? Amid all the bickering, Europe’s leaders have actually managed to implement a surprising amount of reform. “All of the measures taken at the European level and at the national level have done enough for now to contain the crisis,” says José Ignacio Torreblanca, head of the Madrid office of the European Council on Foreign Relations.

Indeed, a European policymaker who had gone into hibernation a year ago would be shocked upon waking today at how much progress his colleagues have made toward strengthening the monetary union. Last May, the E.U. cobbled together a $1 trillion rescue fund for indebted countries, which it later agreed to transform into a permanent bailout system. Starting this year, euro members must submit their national budgets to the E.U. for review before sending them to their parliaments in an effort to better coordinate fiscal policies. Governments have also approved new rules to press members to reduce debt more quickly, tougher sanctions on those that miss debt and deficit targets, and a “euro-plus pact” containing a series of guidelines on everything from retirement age to corporate taxes aimed at improving the competitiveness of Europe’s economies.

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Equally impressive reforms have been taken in individual capitals. In Spain, Prime Minister José Luis Rodríguez Zapatero has loosened up the labor market, reformed the pension system and started rebuilding a banking sector laid low by a housing bust. Zapatero’s government has also reduced the budget deficit to 9.2% of GDP last year from 11.1% in 2009 and plans to shrink it to 6% this year. Investor sentiment toward Spain has improved to the point that Finance Minister Elena Salgado felt confident enough to proclaim in early April that she “absolutely ruled out” any risk of contagion. The success in Madrid has bolstered hopes that Spain can act as a fire wall, limiting the debt crisis to Greece, Ireland and Portugal. Though painful for those three economies, they are small enough — at a combined 6% of euro-zone GDP — that their woes likely won’t pose much danger to European growth.

So is the crisis over? No, it’s not. “The euro zone is not out of the woods,” says Neil MacKinnon, head of global strategy at investment bank VTB Capital in London. “Whether the monetary union in its current format is viable in the long term is highly debatable.”

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The biggest worry remains all that debt. The bailouts of Greece, Ireland and Portugal bought those governments time to fix their finances but didn’t reduce the debt burden itself. Politicians will continue to find it hard to push through the budget cuts and tax hikes necessary to bring down debt levels. Portugal’s Prime Minister, José Sócrates, resigned in late March after his austerity program was rejected by parliament. Greece’s sovereign debt, at 140% of GDP, is so onerous that Clemens Fuest, a member of an advisory board of the German Ministry of Finance, puts the chances of the government’s paying it back at “close to zero.” If he’s right, Greece will need a restructuring that hoists losses onto creditors and potentially taxpayers. “It is very likely that one or more countries will declare insolvency, which could lead to turmoil in financial markets, because there is no plan to deal with that,” says Joachim Scheide, head of the forecasting center at the Kiel Institute for the World Economy.

In Ireland, meanwhile, unresolved banking troubles continue to defy policymakers. Dublin announced in late March that its banks require $35 billion in capital on top of the $66 billion already injected. Spain has ordered its banks to shore up their capital by September. Ratings agency Moody’s estimates the Spanish banks could require as much as $170 billion in fresh capital in a worst-case scenario, far above the central bank’s current estimate of $22 billion. Though those costs still might not be big enough to toss Spain into insolvency — its government debt relative to GDP is smaller than Germany’s — they could undermine confidence in the Spanish economy.

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Nor will the weakest euro-zone economies have the luxury of growth to ease the trials of reform. Amid continued budget cuts and high unemployment, recovery seems far off, making it even harder to control deficits and debt. The International Monetary Fund expects Greece’s GDP to decline by 3% in 2011 — its third consecutive year of contraction — and Portugal’s by 1.5%. Ireland and Spain may grow, but barely. The early-April decision by the European Central Bank to raise its benchmark interest rate (from 1% to 1.25%) may make sense for economies like Germany’s, where growth is buoyant, but on the European periphery it could dampen consumption and investment.

Most of all, critics of European policy still argue that not enough has been done to repair the working of the euro zone itself. Many of the new rules, including the euro-plus pact, are little more than gentleman’s agreements. “All these frameworks are a step in the right direction but not the quantum leap needed to make the euro zone really stable,” says Carsten Brzeski, a senior economist at banking giant ING Group in Brussels. Bolder proposals, like the introduction of a Eurobond jointly backed by euro-zone governments, have fallen victim to domestic politics in rich countries, where voters resist seeing their taxes diverted to help their neighbors.

(Already Hurting, Portugal Must Cut Deeper for a Bailout.)

All these outstanding problems leave many euro watchers a bit queasy about where the monetary union is headed. Javier Díaz-Giménez, an economist at IESE Business School in Madrid, says he is no more confident about the euro’s future today than a year ago. “I don’t think enough progress has been made in establishing credible rules on euro management,” he says. Without them, “the euro area is at the mercy of investors.” Stay tuned.

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