The Eurozone needs a grand political bargain

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Linda Zeilina: Good Morning Sony, welcome to the first in our new series of 'Conversations with Re-Define'. So, market confidence seems to have returned and there is certain optimism in the air and ECB president Draghi has said that there are signs of ‘positive contagion’. Would you say that the Eurocrisis is finally over?

Sony Kapoor: I think that the optimism has gone too far. The Eurozone real economy is continuing to contract and the situation in Italy and Spain, both of which are amongst the biggest economies in the Eurozone, is particularly dire. France is not doing well either; the Greek economy is now 20% smaller than it was at the start of the Eurocrisis. Nor are Ireland and Portugal in great shape. These are just the countries that we already knew were in trouble. If you cast your net a bit broader, Austria, the Netherlands, Finland, which are supposed to be the stronger economies, are also in trouble and Germany is not immune when all economies around it are shrinking.

On the financial front, European banks continue to be very largely dependent on public support, both implicit and explicit. The ECB, for instance, continues to provide large amounts of funds to the banks which the banks would not be otherwise have the access to in the markets. There is still a significant amount of capital support, and there is talk of the European Stability Mechanism needing to inject even more capital into the banks, especially in Spain. The European Banking system is still essentially on life support and is not providing the real economy the kind of support it needs, particularly in the crisis countries.

If we look at the political aspect, the fact that the Greek government and Portuguese governments have survived and continue to push deeply unpopular austerity is a positive surprise as was the Situation in Spain up until the government got embroiled in the party funding scandal. Angela Merkel remains especially popular, so at the individual level the political system seems to be ok. But it is hard to see how this can continue for very long.

The longer austerity goes on, the longer the divergence between the stronger economies such as Germany and the weaker ones such as Spain continues, the more political support will be lost. The weakening of Portugal’s grand-coalition, the uncertainty about the Italian election (we do not know who will be elected and whether the government will be stable), the loss of confidence in the Rajoy’s government and the Hollande’s bad poll ratings are all harbingers of trouble as support for governments starts to erode across most Eurozone economies.

That is before one starts looking at what is going on in the Eurozone politics. One phrase I keep hearing again and again in Germany is “if the Catalans are not willing to pay for the rest of Spain, why should we?” That is a very dangerous, though understandable sentiment which blocks any sensible solution to the Eurocrisis. There seems to be a political stalemate at the European level. There is very little scope for anything big and ambitious happening – but that is exactly what we need, because the current economic trajectory will continue to lead us into a disaster. Overall, the political space has shrunk to a point where it may no longer be enough to tackle the scale of the economic and financial problems the Eurozone faces.

However, of all the dimensions of the Eurocrisis, it is the social one that that concerns me most.  Since the crisis started, we have built in Europe a constituency of millions of people, particularly young people, who have very little stake in society, who face a very bleak future and who have nothing to lose. This is exactly the breeding ground for social unrest of a large scale. Who knows what may happen the next time Spanish youth protest and the police cracks down on it, with somebody getting injured or killed. Who knows what may happen the next time yet Spanish house holder, commits suicide. We do not know what would happen and we would not really want to find out, but this highlights how fragile the social fabric has become.

All in all, if you look at the combination of the political, financial, economic and social factors, the Eurozone remains in deep trouble. The optimism in the markets is just not justified on the basis of these developments on the ground and in the real economy so cannot continue without further political action, more measures by the ECB and a long-overdue change in strategy.

Linda Zeilina: One of the reasons for the optimism seems to be the belief that the markets can read the signals best. The political dimensions do seem to have stabilised to a certain extent as well. So what would you say were the key missed opportunities from last year, and in terms of this year what would be the essential steps to take to mitigate the negative impacts that you have just spoken about?

Sony Kapoor: I guess it is fair to ask if the politicians and the ECB have responded every time we have edged close to the cliff. I think yes, every time we have stared disaster in the face, there has been some political support forthcoming, as well as from the ECB. However, this has always been too-little and often too-late after much unnecessary economic and political damage has been done.

The two most important things people refer to are 1) a Greek exit being temporarily removed from the realm of possibility 2) and the ECB’s pledge to do whatever it takes to prevent a Euro-break up. These are important but we must remember that it was not the markets that first came up with the idea of Greece leaving the Eurozone, and it was not the markets that speculated about the Euro break-up. These were political statements that came out of the mouths of our most influential politicians. All we have managed to do then is simply to put these two genies of things going really bad – either through the Greek exit or a Euro break up – back in the bottle. We have removed those tail-risks which we had ourselves had put on the table in the first place.

Essentially, we still have not done much on bolstering the real economy nor have we tackled the problems in the financial system. We continue down the deeply flawed austerity-at-all-costs path. Partially correcting the mistakes made by our leaders is not a recipe for restoring confidence, so the fundamentals remain very weak.

Linda Zeilina: Would you say that as it stands at the moment there is no long-term political strategy in place that would mitigate these risks or hamper the spread of panics that occasionally overwhelm the Eurozone? Do you believe that there needs to be more political will? What is the key element that seems to be missing?

Sony Kapoor: Absolutely, there is not enough that has been done in order to tackle the fragility. Things could easily go wrong the next time we encounter a problem. For example, if the Italian election delivers an uncertain outcome, if the Spanish government gets further embroiled in corruption scandals – there are many, many things that can go wrong. The list of things that can go wrong, that can re-introduce panic is much longer than the one with things that go right or that can help tackle the crisis. The whole banking union discussion that was the one-horse race the European policy makers engaged in last year, simply because there was no room for other things (with the Eurobonds being rejected and no appetite for action on the fiscal front). But as Charles Goodhart and I wrote in the Wall Street Journal, the Banking Union has become a sham.

It will do nothing to actually tackle the ongoing crisis. Perhaps it may be helpful for the next crisis we have after 2020. However, as things stand today, it can do little to tackle panic if it arises in Spain or Greece and nothing to support the banking sector if it requires further capital injections. To the extent this discussion crowded out other more important issues, it may even have been counterproductive.

On the fiscal front, the IMF’s mea culpa essentially saying ‘we have been wrong, we underestimated the economic contraction that would result from the fiscal adjustment’ presented a great opportunity to change course at the summit of European leaders in December. It was a perfect opportunity for leaders to save face, and say: ‘The IMF screwed up. In light of the new evidence that has emerged we need to take a second look at the austerity-only policies that we have been pursuing and maybe slow down the pace of austerity or do something else’. But that opportunity was missed once again.

I think what we need at this point is a grand political bargain, and that is one that only Mrs Merkel can offer. We will require a period of five to ten years of adjustment in the European economies which needs to happen both in deficit countries as well as surplus ones not suffering from the immediate crisis. During the course of this adjustment, financial support needs to be made available at reasonable cost to the economies to provide political and economic space for structural reforms and medium-term fiscal adjustment.

Without such a grand political bargain, which gives certainty, predictability and which puts us onto a economically, financially socially and politically sustainable path we are in deep trouble. But such a bargain is not likely, at least not before the German elections. Let us see what happens after that, but I would not hold my breath.

Linda Zeilina: On that rather grim, but perhaps appropriate note, thank you for this very interesting conversation. This is the first in the series of conversations with Re-Define and I hope this provides a good starting point for our forthcoming conversation with Charles Goodhart who is also a member of the advisory board of Re-Define.

Sony Kapoor is Managing Director of Re-Define, Chairman of the Banking Stakeholder Group of the European Banking Authority and a Senior Visiting Fellow at the London School of Economics.

Linda Zeilina co-ordinates the administrative and research programs at Re-Define