The euro crisis is to a great extent a confidence crisis. Sure, there are big underlying problems such as excessive debt and lack of competitiveness in the peripheral economies. But these can be addressed and, to some extent, this is happening already. Meanwhile, a quick fix for the confidence crisis is needed.
The harsh medicine of reform is required but is undermining confidence on multiple levels. Businesses, bankers, ordinary citizens and politicians are losing faith in both the immediate economic future and the whole single-currency project. That is creating interconnected vicious spirals.
The twin epicentres of the crisis are Spain and Italy. The boost they received from last month’s euro zone summit has been more than wiped out. Spanish 10-year bond yields equalled their euro-era record of 7.3 percent on July 20; Italy’s had also rebounded to a slightly less terrifying but still worrying 6.2 percent.
As ever, the explanation is that the summiteers came up with only a partial solution and even that was hedged with caveats. Although the euro zone will probably inject capital into Spain’s bust banks, relieving Madrid of the cost of doing so, the path will be tortuous. Meanwhile, a scheme which could help Italy finance its debt will come with strings attached – and there still isn’t enough money in the euro zone’s bailout fund to do this for more than a short time.
The two countries’ high bond yields aren’t just a thermometer of how sick they are. They push up the cost of capital for everybody in Spain and Italy, while sowing doubts about whether the whole show can be kept on the road. Capital flight continues at an alarming rate, especially in Spain. The so-called Target 2 imbalances, which measure the credits and debits of national central banks within the euro zone, are a good proxy for this. Spain’s Target 2 debt had grown to 408 billion euros at the end of June, up from 303 billion only two months earlier. The Italian one was roughly stable but still high at 272 billion euros.