It is ten years since BNP Paribas suspended redemptions from three hedge funds, due to a complete evaporation of liquidity in the market. This is widely thought of as the “canary in the coal mine” for the events that unfolded during the global financial crisis.
The financial crisis also went on to trigger a crisis of confidence in the euro. In prior years, markets had been sanguine about the level of default risk on Eurozone members government bonds.
Following the introduction of the euro in 2002, the interest rates on ten-year government bonds began to coalesce as if the risk for each country was one and the same. In other words, the market believed that the government debt owed by the export powerhouse that is Germany was roughly equivalent in terms of default risk to a less economically competitive country.
It took the financial crisis of 2008 for the market to realise this grave miscalculation and snap back. And snap back sharply it did – the chronic government deficits and excessive debt came crashing down on the southern Eurozone members.
Before 2008, German and Greek ten-year government bonds had a yield around 5%. By July 2012, the nadir of the crisis, Greek yields were over 30% and rising. During the same period, German yields fell, as the bonds were considered a safe haven. ECB President Mario Draghi uttered those famous words:
“The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Five years later, it looks as though Draghi has been broadly successful at stemming the financial malaise.
The ECB Monetary Policy
With extraordinary monetary policy measures, Draghi has sought to rebuild confidence in the single currency and its economies. Moreover, he has sought to help its ailing banks. The ECB began its own quantitative easing in December 2015, deciding to purchase €60bn of government and corporate bonds every month. Such moves were highly unorthodox, as it could leave the ECB exposed to corporate default.
The ECB also cut its main refinancing rate to zero and its deposit rate to -0.4%. Such low policy rates provide banks with very little incentive to hold onto reserves and instead encourage lending. As a result, lending to companies and individuals has picked up, although it still is below pre-crisis levels.
Temporary factors may have boosted Eurozone growth. However, the structural realities, particularly of periphery Eurozone economies, remain broadly unchanged. In Portugal, bond yields have risen recently as data shows that the harsh structural adjustments required to even challenge German or French competitiveness have still not taken place. In fact, competitiveness in Portugal and Italy has worsened since 2008. Before 2008, unit labour costs in the southern periphery countries rose by substantially more than in Germany and did not correct enough to offset this during the crisis.
More broadly, the Eurozone’s labour market lacks critical flexibility. As an example, in the US, cross-state mobility as a percentage of the total population is around 2.4%. In the same way, within the top 15 EU countries, that figure is less than 1%, a far cry from a common labour market. This sense of stickiness in the labour market continues, with generally restrictive dismissal protection legislation and high labour taxes which make it harder for firms to adjust. For the Eurozone to achieve robust, sustainable growth, these shortcomings must be addressed urgently.
High youth unemployment levels are the legacy of severe fiscal austerity in the most debt-ridden Eurozone countries. Long-term unemployment of this type creates a lost generation through hysteresis effects. If someone is out of the labour market for an extended period, after a while, they can simply become unemployable.
In the two worst affected countries, Spain and Greece, youth unemployment peaked at over 50% and 60% respectively. Policies that were intended to achieve internal devaluation through austerity and wage cuts have caused significant harm to the southern economies and have stoked anti-EU sentiment.
Lastly, some Eurozone economies are heavily reliant on the ECB to purchase their debt. For example, in Spain, most government bond issuance is purchased by the ECB. This could have serious implications for government debt sustainability should the ECB decide to withdraw its support in the market. It is most likely for this reason and others that the ECB will remain ultra-accommodative for the foreseeable future.
The Eurozone outlook is brighter today than it has been in many years. Government finances and the outlook for business investment are steadily improving. Moreover, the global economy is growing at a relatively healthy rate which provides avenues for exports and foreign investment. Low inflation has also been a boon for consumers who have seen real incomes rise as a result and this is likely to continue over the next few years as inflation has yet to make its presence felt.
Historical low levels of unemployment in Germany are not creating a corresponding response in prices. Moreover, the dollar has lost its lustre recently which is likely to reduce imported cost pressures, at least temporarily. With such low inflation, there is little scope for an interest rate rise by the ECB. This accommodative stance will continue to support investment. Indeed, the euro has risen significantly recently on the back of promising economic data and could go as high as $1.25.
Taking that into account, the euro’s strength has different effects on Germany, Spain and France. A stronger euro tends to hurt the predominantly less industrialised economies the most as they are less competitive than the northern economies and their exports tend to be more price sensitive. If the euro continues to strengthen it could undermine the recovery by raising export prices.
Earnings for European companies have already been hit. What happens will depend on how the euro performs and how fast the global economy expands to act as a counterbalance. The Eurozone is by no means out of the woods, long-term robust growth is impossible without vital reform, but for the moment it is at least showing promising signs of growth.