The Eurozone - where now?

Having just arrived home from a short trip to Vienna, where little concern about the Eurozone was detectable, it is curious to observe the diverse mix of views here in the UK. Apparently the UK is isolated in Europe as never before, allegedly we were so determined to protect the UK's interests in the City - financial markets, banks, etc - that we lost sight of the main issue for Friday's EU meetings, namely to save the Euro. On the other hand, commentators are already saying that the Brussels deal agreeing a more disciplined approach to fiscal matters across the Eurozone (and more widely, it seems) is either unworkable or economically foolish or both. And it's hard to find any views anywhere suggesting that somehow the Eurozone is now 'safe', and will comfortably weather what remains of the current crisis.

So what on earth are we to believe? Was Friday's meeting a lucky escape for Britain, or a disaster of the first order? And is the Eurozone now on track to a better, more secure future? It's too soon to know all the answers yet, but a few pointers can usefully be suggested.

First of all, it does seem that the UK played its diplomatic cards quite poorly, for the meeting was basically about new measures needed to support the Euro, something that is quite clearly hugely important for the UK, yet we managed to irritate everyone else by demanding guarantees about the UK financial sector before we could agree to anything. That was unfortunate, and I think a bad mistake, though perfectly understandable given the domestic political pressures that Mr Cameron faced. However, on this occasion he would have done better to face down the pressures in order to be part of what had to be done for the wider Europe. Instead, we are left isolated and, for the moment, apparently friendless. No doubt we shall recover, but great damage has been done.

While Friday was therefore not a great day for Britain, it wasn't wonderful for the Eurozone either. For the agreement on a more disciplined approach to fiscal policy appears to envisage government deficits being maintained below 0.5% of GDP, a very tight limit, far stricter than the Maastricht conditions, and almost certainly unachievable. Assuming that governments nevertheless make serious efforts to keep their deficits within or close to this limit, one can see that across the region there will be tax rises and spending cuts even more stringent than what was already unfolding. This cannot but depress aggregate demand, leading to lower output and employment across the Eurozone, and at best economic stagnation for the EU. On the one hand, this is really bad news for Europe; on the other, it might give rise to political pressures in individual Eurozone states  that could render the agreements unsustainable: in other words, electorates might simply decide that they've had enough of austerity and recession, and that they would like to see some economic growth again.

The new agreement is a bit like a toughened up version of the old Stability and Growth Pact that was supposed to ensure that Eurozone members kept their public finances in decent order; and that failed rather quickly when Germany and France decided that their domestic political interests were best served by ignoring it, not a good message for everyone else. Lacking credible enforcement mechanisms, the new agreement can be expected to suffer the same fate, I fear. Whether the financial markets in the coming weeks will regard it as credible remains to be seen.

In any event, the new agreement is based on an incorrect diagnosis of the current crisis facing the Eurozone, and therefore addresses the 'wrong' problem. It sees the crisis as a consequence of lax fiscal management by the member states, hence needing a new fiscal framework in place from sometime next year. But for most of the countries currently considered to be 'in trouble' (other than Greece), their fiscal management before 2008 was impeccable. The real problem (e.g. in Ireland) was the bubble of private credit, bank failures, and public rescues that converted private to public debt. There is a thus a need to be discussing how we should deal with all this (formerly) private debt, and how far states should or can guarantee it. It is also urgent to deal with both the liquidity problems faced by still solvent sovereigns (such as Italy) and to manage default by those clearly insolvent (such as Greece), preferably within the Eurozone. All this is both difficult and important, but it doesn't seem to me that it was greatly advanced by Friday's discussions.

The other urgent matters that got nowhere on Friday were the questions of how to get growth going again in Europe and how to improve the competitiveness of the weaker members. I think the UK might have had positive things to offer in such discussions - even though our own domestic policy is currently heavily slanted towards austerity - but it's likely that we shall be excluded from many of the discussions that must soon take place. That's a great pity, and I hope our isolation from Europe will not prove to be a lasting element of UK policy.

More on these important topics in later posts.