A further option, largely rejected across the region, would be to apply elements of federalism to the region in place of wiping external deficits, where the eurozone will act as a ‘transfer union’ that allows for monetary transfers from surplus countries to deficit countries.
During the lengthy process of ensuring all of these conditions are met, there will be a risk of major and long-lasting economic, financial, social and political instability. For the financial markets, this points to a depressed level for asset prices due to the high levels of risk volatility.
The financial markets sometimes believe that the eurozone crisis will be solved rapidly
Admittedly, there has been progress – albeit rather limited – towards solving the eurozone crisis. For instance, the European Central Bank implemented Very Long-Term Refinancing Operations (VLTRO) in late 2011, and the European summit in June 2012 resulted in positive decisions for banking supervision and recapitalisation. There is promise too with the likely implementation of the European Security Mechanism.
These actions have all led to a major, although temporary, improvement in financial markets. However, financial market participants should understand that the eurozone crisis will be very long, given the developments that are needed to end it:
The long-term developments required to end the eurozone crisis
1. Rebalancing of balance sheets
In the eurozone as a whole - and especially in some countries such as Spain, Greece, Ireland, and The Netherlands - an imbalance has appeared in the balance sheets of private economic agents between liabilities (due to a very high private-sector debt ratio) and assets (due to the bursting of the real estate bubble and the fall in real estate prices).
As long as this balance sheet mismatch lasts, the private sector has to deleverage and therefore reduce its spending, which leads to sluggish growth. Also, private borrowers’ solvency will remain poor, which means that there is no end in sight for the banks’ problems.
2. Restoration of full employment
In the aftermath of the Lehman bankruptcy in 2009, there were heavy factory job losses due to the fall in global trade. Afterwards, the bursting of the real estate bubble triggered a decline in construction employment too.
Currently, many countries (e.g. France, Italy, Spain, Greece, Ireland, and Portugal) have a very high level of unemployment. This has generated a depressive cycle, because high unemployment leads to a decline in labour's bargaining power and a fall in real wages.
The crisis will not end before economies have pulled out of this depressive cycle, i.e. when job losses have been offset by new jobs. But this process has not yet even started, and would require several measures to be adopted in order to do so. These would include attracting new activities to these countries and reindustrialising them. This is not happening, however, and is reflected in the on-going decline of industrial production capacity.
3. Elimination of fiscal deficits
The sovereign debt crisis has occurred because of excessive fiscal deficits in many countries. Governments obviously need to eliminate these fiscal deficits in order to permanently drive down long-term interest rates.
But today we can see a very worrying development: the fiscal deficits are not shrinking – on the contrary, they are increasing because of sluggish activity.
4. If there is no federalism, the structural external deficits must disappear
Some countries (e.g. Spain, Greece, Portugal, and France) have structural external deficits because of the small size of their exporting sectors, especially in industry. This situation is not sustainable, since these countries are accumulating a continuously growing external debt, and will end up becoming insolvent.
There are then only two solutions to this unsustainable situation, both of which will take a very long time: federalism, or reindustrialisation of countries with a deficit.
We should not expect a rapid end to the crisis in the eurozone
For the time-being, we are seeing major problems when it comes to implementing these long-term developments, and federalism is still off the table.
But for the eurozone crisis to end, all of the mentioned conditions must be met.
The economic, financial, social and political uncertainty will therefore be pronounced in the eurozone for a long time to come – we would estimate about 20 years.
