Hugo Dixon

Beware the “F” word. The European Central Bank and, to a lesser extent, the zone’s political leaders have bought the time needed to resolve the euro crisis. But there are signs of fatigue. A renewed sense of danger may be needed to spur politicians to address underlying problems. It would be far better if they got ahead of the curve.

The big time-buying exercise was the ECB’s injection of 1 trillion euros of super-cheap three-year money into the region’s banks. A smaller breathing space was won last week when governments agreed to expand the ceiling on the region’s bailout funds from 500 to 700 billion euros.

These moves have taken the heat out of the crisis – both by easing fears that banks could go bust and by making it easier for troubled governments, especially Italy’s and Spain’s, to fund themselves. Data from the ECB last week shows how much of the easy money has been recycled from banks into government bonds. In February, Italian lenders increased their purchases of euro zone government bonds by a record 23 billion euros. Spanish banks, meanwhile, increased their purchases by 15.7 billion euros following a record 23 billion euro spending spree in January.

The risk is that, as the short-term funding pressure comes off, governments’ determination to push through unpopular reforms will flag. If that happens, the time that has been bought will be wasted – and, when crisis rears its ugly head again, the authorities won’t have the tools to fight it.

Early signs of such fatigue are emerging. One is the tendency of politicians – most recently, Italian Prime Minister Mario Monti – to say that the worst of the crisis is over. They may wish to take credit for their crisis-fighting skills or relax. But it is too early to declare victory.

At a dinner in Madrid earlier this month, the main complaint about Mariano Rajoy was that the new prime minister was treating the electorate like children. Many of the guests, supporters of Rajoy’s Popular Party (PP), understood that Spain had to cut its fiscal deficit and restore its competitiveness. But they didn’t like the fact that the prime minister hadn’t been frank about his plans.

In advance of last November’s general election, Rajoy said he wouldn’t raise taxes, make it cheaper to fire people or cut the welfare state. But he has now done the first two. After this week’s election in Andalusia, Spain’s largest region, he is expected to do the last.

Rajoy’s camp doesn’t see any problem in failing to be upfront. It would have been foolish to talk too much about austerity in the general election campaign as that might have frightened the voters. For the same reason, it would be foolish to tell them about reforming the welfare state in advance of the Andalusia election.

Francois Hollande’s sins are more those of omission than commission. The headlines might suggest otherwise. The socialist challenger to Nicolas Sarkozy as France’s next president has promised to cut the pension age to 60, tax the rich at 75 percent, renegotiate Europe’s fiscal treaty and launch a war on bankers. But these pledges aren’t as bad as they look. The real problem is that Hollande, who has a strong lead in the opinion polls, isn’t addressing the need to reform the country’s welfare state.

Hollande is a moderate. Like Sarkozy, for example, he is promising to cut the budget deficit to 3 percent next year, from 5.8 percent as estimated by the European Commission in 2011. But he still had to throw the left some red meat in the election campaign, which runs until May. That’s not just to prevent votes drifting to Jean-Luc Mélenchon, the far-left candidate. It’s also to avoid being outflanked by Sarkozy’s own populist attacks on corporate fat cats and bankers.

Still, the precise pledges probably aren’t what they seem, as I discovered on a trip to Paris last month.

Bailout may not be a four-letter word. But many of the rescue operations mounted to save banks and governments in the past few years have been four-letter acronyms. Think of the TARP and TALF programmes that were used to bail out the U.S. banking system after Lehman Brothers went bust. Or the European Central Bank’s LTRO, the longer-term refinancing operation. This has involved lending European banks 1 trillion euros for three years at an extraordinarily low interest rate of 1 percent.

The markets and the banks have jumped for joy in response to all this liquidity being sprayed around. So have Italy and Spain, whose borrowing costs have dropped because their banks have been able to take cheap cash from the ECB and recycle it into their governments’ bonds — making a profit on the round trip. But as has been the case with other four-letter bailouts, the LTRO has come in for criticism — most of it a variation on the theme that the way to treat debt junkies isn’t to give them another heroin injection.

One problem is that European governments could now feel less pressure to reform their labour laws and do the other painful things that are needed to get their economies fit. Another is that banks may delay actions that are required to let them stand on their own two feet: such as rebuilding their capital buffers and raising their own longer-term funds on the markets.

Europe needs a growth strategy. In the short term, that means preventing an austerity spiral. In the long run, it means structural reform and a drive to create a genuine single market. The European Union summit this week is a chance to aim at both targets.

The euro zone crisis may be receding. Last week’s temporary fix of Greece’s problems with a 130 billion euro bailout is the most recent cause for optimism. But so long as the region cannot grow – and the European Commission has just forecast zero growth this year for the European Union as a whole and shrinkage for several countries including Italy and Spain – there is a risk of sliding back into crisis.

The European Central Bank’s provision of 500 billion euros of three-year money to the banks before Christmas – and the promise of a similar cash injection this week – has lifted spirits in financial markets. Some of that money will find its way into the real economy. But while monetary policy is lax, fiscal policy is tight. No fewer than 23 of the EU’s 27 countries are in what are known as “excess deficit procedures”, which require them to bring their annual borrowing down to less than 3 percent of GDP over the next year or so. Under the so-called “six pack” system of fiscal discipline, countries can be fined if they fail to stick to the required austerity.

Mario Monti’s ability to take a crisis and turn it into an opportunity may one day be taught as a case study in political economy. When Italy’s technocratic premier succeeded Silvio Berlusconi last November, the country’s 10-year bond yield was above the 7 percent level that had driven Greece, Ireland and Portugal to seek bailouts. Now it is 5.5 percent – still high but moving in the right direction.

Countries with high debt levels like Italy – its borrowing is 120 percent of GDP – are prone to self-fulfilling prophecies on both the upside and the downside. If investors think a government will go bust, borrowing costs rise which, in turn, makes bankruptcy more likely. But if markets think it is solvent, borrowing costs fall and that means it’s unlikely to fail.

In Italy, where I spent much of last week, there have been spirals within spirals. One has been via domestic politics. Monti has so much credibility that he has been able to reform the pension system, liberalise a raft of monopolistic industries and launch a high-profile crackdown on tax evasion. That has helped cut Italian bond yields, further boosting his credibility.

Investors are feeling more optimistic about the euro crisis. So are policymakers. That much was evident last week at the World Economic Forum’s annual meeting in Davos. There was much satisfaction over the early performance of the Super Mario Brothers – Mario Draghi, president of the European Central bank, and Mario Monti, Italy’s prime minister. What’s more, a deal may be in the works to build a bigger firewall against contagion, constructed out of commitments from euro zone members and the International Monetary Fund. And it looks like there will be another short-term fix for Greece.

But three bad fairies were lurking at the Davos feast. Spain and France are relatively new problems and Greece is an old one. All three are powerful menaces.

Madrid is staring at a particularly vicious version of the austerity spiral afflicting most of the euro zone. The last government missed its fiscal targets, leaving the country with a budget deficit of 8 percent of GDP in 2011. The programme agreed with the European Union commits Spain to cutting this to 4.4 percent in 2012. Doing so would be hard in good times. Trying to reach this target when GDP is set to shrink by at least 1.5 percent and the unemployment rate is already 23 percent would be nearly suicidal.

The euro zone shouldn’t rely on a bailout from the rest of the world. The International Monetary Fund is asking for an additional $600 billion to help deal with the euro crisis. But the euro zone, which is vastly richer than most of the rest of the world, should find the money to solve its own problems. It will be bystanders in the developing world that may need help if the euro blows up.

One can see why the IMF wants more money. An additional $600 billion on top of its existing firepower of $390 billion would take it up to a nice round number of $1 trillion. Not only would that give its bosses more swagger as they crisscross the world fighting fires but it would allow the IMF to play a big role in any bailout of a large euro zone country such as Italy.

But why should the rest of the world bail out the euro? The rich normally help the poor. But GDP per capita in the euro zone was $33,819 in 2011, more than five times that in the developing world, according to the IMF. As things stand, 57 percent of the IMF’s existing loans are to the euro zone, according to the Center for Economic and Policy Research. It’s not surprising that other countries are hardly rushing to funnel yet more money its way.

Watch Athens more than Standard & Poor’s. The biggest source of immediate trouble for the euro zone could be the one country the ratings agency didn’t examine in a review that led to the downgrade of France and eight other states. Even if the short-term shoals can be navigated, the rest of the zone won’t find it easy to get by Greece.

The points S&P made when stripping France and Austria of their triple-A ratings and knocking two notches off the ratings of the likes of Italy and Spain were valid. It is true, for example, that policymakers can’t agree what to do to solve the euro crisis and that “fiscal austerity alone risks becoming self-defeating.” But these points, as well as the prospect of S&P downgrades, were already in the market.

Meanwhile, what Mario Draghi said last week about “tentative signs of stabilization” is true. The European Central Bank (ECB), over which Draghi presides, is itself partly responsible for that stabilization by virtue of providing 489 billion euros of three-year money to banks just before Christmas. Mario Monti’s promising beginning as Italy’s prime minister is the other main factor. The Super Mario Brothers have got off to a good start.

Semantics could help save the euro zone. There is a crying need to distinguish between fiscal austerity and structural reform.  The endless austerity programs adopted by the GIIPS — Greece, Ireland, Italy, Portugal and Spain — threaten to crush their economies so much that they are socially unbearable. By contrast, reforming pensions, labor markets and the like would be good for long-term growth. A policy mix that emphasizes the latter and draws some sort of line under the former is needed to stop the euro crisis spinning out of control.

Europeans have become grimly familiar with austerity spirals over the past two years. A government that needs to cut its fiscal deficit embarks on a program of tax hikes and spending cuts. The snag is that this fiscal squeeze, in turn, squeezes the economy — partly via the direct impact of cash being sucked out of the private sector and partly because the private sector loses confidence. The depressed economy means the government’s tax take doesn’t rise nearly as much as envisaged. So the deficit doesn’t decline much and, as a percentage of shrunken GDP, it falls even less. The governments’ creditors, led by Germany, then demand another round of austerity to get the program back on track. With each round, the howls of pain from the population increase, belief that there is light at the end of the tunnel declines and the government’s political capital shrinks.

The Greeks, Irish and Portuguese have been trying to run up this down escalator the longest. Italy and Spain are now embarking on the same regime. Yet more doses will be required over the coming year if the policy mix is unchanged. After all, last year’s budget deficits are expected to be about 10 percent for Greece and Ireland, 7-8 percent for Spain and Portugal (if a one-off pension transfer is ignored) and 4 percent for Italy.