Financial conditions in the euro zone have significantly improved since the summer, when euro zone risks peaked because of German policymakers’ open consideration of a Greek exit, and the sovereign spreads of Italy and Spain reached new heights. The day before European Central Bank President Mario Draghi’s famous speech in London in which he announced that the ECB would do “whatever it takes” to save the euro, bond yields in Spain and Italy were at 7.75 percent and 6.75 percent, respectively, and rising. When the ECB announced its outright monetary transactions (OMT) bond-buying program, the euro zone was at risk of a collapse.
Since then, risks have abated significantly, thanks to a number of factors:
The ECB’s OMT has been incredibly successful in reducing the risks of breakup, redenomination and a liquidity/rollover crisis in the public debt markets of Spain and Italy. Although the ECB has yet to spend a single additional euro to buy the bonds of Spain and Italy, both short-term and longer-term sovereign spreads against German bonds have fallen substantially.
Following a number of political and legal hurdles, the successful operational start of the European Stability Mechanism (ESM) rescue fund provides the euro zone with another €500 billion of official resources to backstop banks and sovereigns in the euro zone periphery, on top of the leftover funds of its predecessor, the European Financial Stability Facility (EFSF).
Realizing that a monetary union is not viable without deeper integration, euro zone leaders have proposed a banking union, a fiscal union, an economic union and, eventually, a political union. The last is necessary to resolve any issue of democratic legitimacy that might result from national states transferring power from national governments to EU- or euro zone-wide institutions. This transfer of power also would have to involve the creation of such institutions to ensure solidarity and risk-sharing are developed in the banking, fiscal and economic unions.
The open talk in the summer by some German authorities about an exit option for Greece has turned into a tentative willingness to prevent and postpone such an exit. There are several reasons for this. First, Greece has done some austerity and reforms in spite of a deepening recession, and the current coalition is holding up. Second, an orderly exit of Greece is impossible until Spain and Italy are successfully isolated. Such an exit would lead to massive contagion, which would hurt not only the euro zone periphery but also the core, given extensive trade and financial links. Third, an economic disaster in Greece would be damaging to the CDU Party’s chances of winning the German elections. Thus, even when Greece inevitably underperforms on its policy commitments, Germany and the troika (the IMF, EU and ECB) will hold their noses and keep the funds flowing as long as the current coalition holds up.
Given these developments, the risk of a Greek exit in 2013 has been significantly reduced, even if the risk of an eventual Greek exit from the euro zone is still high, close to 50 percent by my estimation. Meanwhile, the narrowing of Spanish and Italian sovereign spreads has significantly diminished the risk that either country will fully lose market access and be forced to undergo a full troika bailout like Greece, Portugal and Ireland. Both Spain and Italy may in 2013 opt for a memorandum of understanding (MoU) that opens the taps of ESM and OMT support, but such official financing would inspire confidence as it would not be associated with rising, unsustainable spreads and a loss of market access.
While there is a much lower likelihood of disorderly events in the euro zone, there are still significant obstacles to deeper integration, as well as country-specific economic and political vulnerabilities. The biggest obstacle to the formation of a banking, fiscal, economic and political union is that Germany is pushing back against the time line for action, with the initial skirmish on ECB supervision of euro zone banks. This backpedaling reflects deep German skepticism on whether the resolution of the euro zone crisis requires a move toward greater union. Without a more credible commitment to austerity and reforms from euro zone periphery countries, lurching forward would imply that risk-sharing will turn into a large, long-term transfer union, which is unacceptable to Germany and the core. Thus, Germany will do whatever is necessary to delay the integration process, at least until after elections in fall 2013.