A strange calm has settled over Europe. Following Mr. Draghi’s July 2012 promise “to do whatever it takes” to save the euro, which the head of the European Central Bank followed shortly thereafter with a new program of potentially unlimited bond buying known as “outright monetary transactions,” the market panic evaporated. Since then super-high bond yields have come down to more reasonable levels, allowing fiscally and financially stressed debtor countries in the euro-zone to (re)finance their public-sector borrowing needs a lot more easily than before. Even Greece has been able to borrow in the single-digits for the first time in three years.

This calming of once-panicky debt markets has led to optimistic assessments that the worst of the crisis has passed. Draghi himself declared at the beginning of the new year that the euro-zone economy would start recovering during the second half of 2013. He talked of a “positive contagion” taking root whereby the mutually reinforcing combination of falling bond yields, rising stock markets and historically low volatility would set the positive market environment for a resumption of economic growth across the euro zone. Christine Lagarde, as the head of the IMF part of the “troika” (i.e. ECB, IMF, and European Commission) managing the euro-zone crisis, declared at the World Economic Forum in Davos a few weeks ago that collapse had been avoided, making 2013 a “make-or-break year.”

A break from the storm?

All this begs the obvious question whether this major shift in mood is justified and as such durable or just a temporary break before the next storm. The answer to this question is unclear, to say the least. It could go either way – the beginning of sustained recovery around the corner or imminent resumption of market panic provoking further stress in the euro-zone system.

In favour of the now remarkably widespread optimism among European and non-European financial-market players is the prevailing sense that – painful as the process might have been – several of the debtor countries have made significant progress in their adjustment processes. Specifically, we can see that Ireland, Spain, Portugal or even Greece have been able to lower their current-account deficits substantially to the point where at least the first three of these may end up running current-account surpluses in 2013 – a very significant turnaround which may help their economies recover earlier than thought.

More generally, those deficit countries in the periphery of the euro-zone have gone through an austerity-driven and recession-mediated “internal devaluation” process which in the absence of other adjustment options (via lower exchange- and/or interest rates) has improved their relative labour unit costs and so left them more competitive as a result.

Further feeding positive market sentiment is the spreading sense that some key structural reforms needed for proper completion of the single-currency project are finally being moved to the front burner. This is especially true following the launch last September of the €500bn. European Stability Mechanism (ESM), the new permanent lender-of-last-resort mechanism for euro-zone members in crisis. In the meantime a majority of EU countries have ratified the so-called “fiscal pact” which gives the European Commission far more powers than before to monitor national budgets and impose tough deficit limits on member countries, thereby significantly curtailing their hitherto sacrosanct sovereignty over fiscal policy. A third major institutional reform, that of constructing a banking union, has also made recent progress with agreement in December 2012 to create a single banking supervisor under the auspices of the ECB.

The lingering threat from austerity

But all these tangible improvements may easily come to naught in which case renewed turmoil in the sovereign-bond markets will be just a matter of time. Most troubling in this context is the doom-loop dynamic of persistent fiscal austerity across the continent. To the extent that such deficit-cutting measures push an already shrinking domestic economy deeper into recession and thereby trigger automatic fiscal stabilisers, they may be self-defeating while at the same time depressing economic activity further. Whatever re-balancing adjustments have already taken hold, they may in the end be overpowered by the debt-deflation spiral which a continental multi-year commitment to tax hikes and savage spending cuts will inevitably bring about. Add to this growing political polarization and social unrest in the wake of deepening economic crisis, crystallized around double-digit unemployment and broadly falling living standards. Much of this translates into public rage against European integration, just when exactly that is needed to a greater degree than ever before.

This dialectic centers above all on the euro’s trade-adjusted exchange rate. To the extent that positive market sentiments drive up the euro against its key trading partners (already by over 10% just in the last couple of months), they will undermine the competitiveness of the euro-zone’s economies which only reinforces recessionary pressures already in place and deepens tensions within the EU’s adjustment processes – a dynamic that can be pushed to the breaking point of an acute banking crisis or major sovereign-debtor default.

More generally, the recent improvements in market sentiment have once again proven that Europe’s political leaders only act when under severe pressure to do so. The moment the situation relaxes, as it has in recent months, they go back to their old bickering and meandering ways, bringing reforms to a halt.

The search for a lasting solution

But the euro-zone cannot afford this stop-go pattern of policy-making in the face of a systemic crisis. It will have to undertake far-reaching reform on several fronts beyond what Europe’s leading politicians have been willing to entertain. If, for instance, you impose a constitutional balanced-budget requirement on nation-states within the union, then you will have to push harder for a new kind of fiscal federalism which gives the European Commission a bigger budget and deficit-spending capacity. The recent EC budget exercise has gone in the exactly opposite direction, locking in seven more years of fiscal austerity at the federal center of Europe. The banking union will have to be extended to include a continent-wide deposit-insurance scheme and resolution fund, both steps more complex and fraught with intra-EU conflicts than the recently launched EU-wide supervisor. Finally, introduction of mutually guaranteed and jointly issued Euro-bonds is the only way to repair the structurally damaged sovereign-debt market, expand the ESM’s crisis-management capacity when needed, and anchor fiscal federalism – all crucial steps needed to overcome this structural crisis.

Given the scope of reforms yet to be undertaken, continued deep recession, and prevailing asymmetries within the euro-zone between debtor and creditor countries, it may be too early to see the “end of the tunnel.” Only time will tell!

This article originally appeared in the Triple Crisis blog.

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