Eurozone Unity Under Threat?

Content Type
Working Paper
Institution
Oxford Economics
Abstract
Ten years after the introduction of the euro, the onset of deep recession in the Eurozone has triggered concern that the single currency might impose intolerable strains upon some members. With some countries hit hard by the impact of the credit crunch, there are mounting concerns about a possible debt default by one or more member states, which in turn might threaten the euro and even the existence of the Eurozone. With the Eurozone economy forecast to contract by 3.1% this year, unemployment is starting to climb steeply and fiscal deficits are soaring. This has raised concerns about deteriorating public finances in a number of countries, leading to sharply wider spreads on government bonds and credit rating downgrades for Greece, Spain and Portugal, with Ireland maybe facing a similar fate soon. And repercussions from the growing economic crisis in Central and Eastern Europe are adding to the problem, with Austria particularly exposed. Rising bond spreads were always intended to be the mechanism that would restrain public spending by more profligate Eurozone countries. But the question now is whether the weaker economies can withstand the strains that a lengthy period of recession will impose and, at the same time, adopt credible medium-term spending plans to ward off the worst of the downturn and retain market confidence. With fiscal deficits already rising as a result of bank bailouts, fiscal packages and recession will push budget deficits far above the 3% of GDP target – Ireland, facing a deficit of 12% of GDP, and Spain will be worst hit. And with rising deficits and higher bond spreads pushing up the cost of debt, countries face a sharp rise in their level of indebtedness, with Greece and Italy seeing debt/GDP ratios around 100%. This deterioration could lead to a further downward spiral if the recession is prolonged and will be a test of countries' euro commitment, which has remained strong thus far despite rising social tensions in some countries. At this stage, the problems remain manageable and the risk of default or of countries leaving the euro is still very low. Bond spreads are still much lower than during much of the 1990s, when countries were striving to qualify for euro membership, and the currency risks attached to leaving the euro would be substantial. Moreover, EU countries that have been exposed to considerable currency strain over the past year are anxious to join the Eurozone as soon as possible, to take advantage of the benefits of a stable currency. While some smaller countries may experience financial difficulties, it seems inevitable that the larger Eurozone members would step in to stabilise the situation – failure to do so would risk contagion spreading to other countries, which in turn would cause even deeper problems for the euro. More policy action also seems likely to counter this threat – although the German government will probably remain reluctant to countenance the scale of expansionary fiscal policy really needed at this time. Current policies inevitably mean a long hard slog back towards fiscal rectitude in the years ahead, with monetary policy also tightening and growth slower than previously expected. Fiscal federalism may also have to be on the agenda. All this will undoubtedly lead to ongoing strains within the Eurozone. And any measures by governments that appear to be protectionist – such as the support for the French car industry – will only fuel these tensions.
Topic
Economics, International Trade and Finance, Regional Cooperation, Treaties and Agreements, Financial Crisis
Political Geography
Europe, Germany