The Eurozone rescue deal agreed last week marks another step on the road towards fiscal burden-sharing and is likely to calm markets, at least temporarily. The absence of any expansion of the European Financial Stability Facility (EFSF), however, should result in Spanish and Italian yields retaining a significant risk premium. The Eurozone seems to be progressing slowly and haltingly towards a full fiscal union, with periodic bouts of market turbulence forcing politicians to accept incremental reforms.
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A fiscally-unified Eurozone would have no sustainability issues. General government net debt is projected by the OECD to be 60% of GDP at the end of 2011 compared with 62% in the UK, 75% in the US and 128% in Japan – see first chart. The 2011 fiscal deficit is forecast at 4.2% of GDP versus 8.7% in the UK, 8.9% in Japan and 10.1% in the US.
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Importantly, this relatively respectable fiscal position does not depend solely on Germany. The rest of the Eurozone is projected to run a deficit of 5.0% in 2011, with net debt ending the year at 64%.
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Last week’s deal conceded further ground on the principle of fiscal burden-sharing, by easing significantly the terms of official lending to the bail-out countries and allowing the EFSF to provide pre-emptive credit lines to countries facing funding difficulties and buy bonds in secondary markets.
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A key weakness of the deal, however, was the absence of any expansion of the EFSF, which has insufficient resources credibly to protect both Spain and Italy from contagion. Yields in the two countries, therefore, may continue to incorporate a sizeable risk premium, with spreads over Germany failing to revert to levels prevailing before the recent crisis. The deal, meanwhile, needs to gain approval in all 17 euro area member states.
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A full resolution is likely to require the transformation of the EFSF, and its proposed successor the European Stability Mechanism, into a “European monetary fund”, able to issue unlimited quantities of “eurobonds” – for which member states are jointly and severally liable – to raise funds for on-lending at non-penal rates to countries following an agreed fiscal programme. A further crisis may be necessary to overcome political resistance to such a fundamental reform (including in potential borrowing countries that would lose their remaining fiscal autonomy).
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Renewed market turbulence could be triggered by disappointing economic performance during the second half of 2011, as suggested by monetary trends, resulting in fiscal slippage relative to current plans. Monetary weakness, however, has recently extended from peripheral to core economies, including Germany – a generalised economic slowdown could push the ECB to the sidelines and allow the euro to depreciate, offering relief to the periphery.
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A debt-weighted average of Eurozone yields has fluctuated in a relatively narrow range since early 2011, reflecting a negative correlation of peripheral spreads and the level of yields in Germany and other core countries – second chart. This may continue, with a near-term modest narrowing of spreads offset by a rise in core yields in response to reduced “safe-haven” demand and in recognition of fiscal dilution.
