European Perspectives
December 2013
Andrew Bosomworth
Your Global Investment Authority
Muddling Through:
The ‘Realpolitik’
of the Eurozone Crisis
Rather than natural resources, geography or culture shaping
a nation’s destiny, economists Daron Acemoglu and James
Robinson propose a different explanation of economic
growth in their book, “Why Nations Fail”. Essentially, they
argue that man-made political and economic institutions
are what actually decide a country’s fate.
Andrew Bosomworth
Managing Director
According to their proposed framework, successful societies display four key
characteristics: centralisation of political institutions, a clear division of
competencies between centre and regions, democratically inclusive
institutions and the willingness and ability to adapt to creative destruction.
Applying this framework to the eurozone reveals a number of shortcomings:
Political institutions are highly decentralised, division of competencies
between centre and regions is skewed, eurozone citizens have learnt that
policies are imposed from outside and low-skilled labour is ill-equipped to
compete internationally.
The politics of crisis
Despite these shortcomings, the eurozone is doing better than what most
critics predicted; yet, markets still assign a not-insignificant probability of a
break-up. While equity indexes of core countries have broadly regained their
2007 level, share prices in southern Europe still languish about 40% lower
and yields on 10-year government bonds are on average still 3% higher than
in core countries. Whether these valuation differences are fundamentally
justified or not depends not only on economics, but increasingly on the
politics of the eurozone. Elections to the European Parliament in May 2014
and the formation of a new European Commission will be important
milestones in shaping the future of both the eurozone and the European
Union (EU). Concerning these visions, the political groups in the European
Parliament can be divided into three main factions that we label the
confederates, the status quo and the federalists. (See Figure 1.)
FIGURE 1: THE SEVENTH EUROPEAN PARLIAMENT (JULY 2009 TO MAY 2014)
Status Quo
61%
Confederate
16%
Federalist
19%
Non-aligned
4%
European Parliamentary Group
Seats
Share
Faction
European People’s Party
274
36%
Status quo
Progressive Alliance of Socialists & Democrats
195
25%
European Conservatists & Reformists
56
7%
European Left-Nordic Green Left
35
5%
Europe of Freedom and Democracy
33
4%
Alliance of Liberals & Democrats for Europe
85
11%
The Greens-European Free Alliance
58
8%
Non-Attached Members
30
4%
766
100%
The dominant political groups prefer the status quo, believing
that existing institutions and treaties suffice. In their view, to
make the EU work better one simply needs to better utilise
the existing treaties. The confederates, meanwhile, aim to
take back powers from the centre and return it to the
national level. For example, some members oppose
immigration, while others would like to dissolve the euro
altogether or even leave the EU. Finally, the federalists believe
Europe in its current form will not succeed. For the euro to
endure, federalists promote transferring more power to the
centre, strengthening the democratic legitimacy of European
institutions and equipping the eurozone with a risk sharing
tool. However, as they outline in their manifesto, “A
Fundamental Law of the European Union”, this would require
major changes to the treaties.
Factions aside, satisfaction with the euro is decreasing.
According to the Eurobarometer survey (see Figure 2), only
51% of survey respondents now support the euro, while an
increasing proportion, 42%, disapprove. Although the
confederates, including EU and euro sceptics, only make up
about 20% of European Parliament votes today, this faction
looks set to gain a larger share in next year’s election.
2
DECEMBER 2013 | EUROPEAN PERSPECTIVES
Confederate
Federalist
Non-aligned
Source: European Parliament, PIMCO as of November 2013
FIGURE 2: EUROBAROMETER - A EUROPEAN ECONOMIC
AND MONETARY UNION WITH ONE SINGLE CURRENCY?
Percent of votes (%)
Collective Share of Factions (%)
60
59
34
33
7
6
2006
For
63
31
6
2007
61
31
8
60
33
7
2008
Against
61
61
60
32
33
33
7
6
7
2009
56
37
7
2010
58
56
37
35
7
7
2011
53
52
53
40
40
40
7
8
7
2012
51
42
7
2013
Don't know
Source: European Commission as of September 2013
Fortunately, the status quo faction, with an almost two-thirds
majority of the European Parliament, will likely remain the
largest faction after next year’s election. The increasing
polarisation among confederates can also be expected to
bring the status quo and federalist factions closer together.
The legitimate question remains whether current policies will
suffice to end the euro crisis. No one knows ex ante with
certainty; but with such heterogeneous countries in the
eurozone, we would venture a negative response.
Progress overshadowed by justified doubts
We must acknowledge that status quo policies have already
achieved a lot. The current account balances of peripheral
countries have increased to a surplus of 1.5% of GDP, up
from a 6% deficit in 2008 (see Figure 3). Even Greece now
runs twin current account and primary surpluses. Likewise,
unit labour costs have fallen, especially in the periphery, and
structural reforms are being implemented.
FIGURE 3: CURRENT ACCOUNT BALANCES AS
PERCENTAGE OF GDP
4
2
The adjustment of external balances came at the cost of
increasing unemployment to just over 12 million persons,
predominately in Europe’s periphery (see Figure 4). In Spain
and Italy alone, the number of unemployed almost doubled
to more than 9 million over the last five years. High and
long-term unemployment is a tinder box for the permanent
atrophy of skills and social unrest. For example, it was violent
social unrest that helped tip Argentina to default in 2001.
The increasing political radicalisation of violence in Greece
should serve as a siren call that there are limits to internal
devaluation and social tolerance.
FIGURE 4: EUROZONE UNEMPLOYMENT
0
-2
14
-4
-6
-8
‘00
‘02
‘04
‘06
‘08
‘10
‘12 ‘13 ‘13
Q1 Q2
Surplus countries: Austria, Belgium, Finland, France,
Germany, Luxembourg, Netherlands
Former deficit countries: Cyprus, Estonia, Greece,
Italy, Ireland, Malta, Portugal, Slovakia, Slovenia, Spain
Source: Eurostat as of 17 October 2013
To date, Greece, Spain and Portugal have been the most
responsive countries to implement structural reforms
recommended by the Organisation for Economic Co-operation
and Development. The significance of the new fiscal and
surveillance tools – known as Two-Pack, Six-Pack and Fiscal
Compact initiatives that give the European Council a de facto
veto right over national economic policies – is probably
underestimated by global financial markets. And the Single
Supervisory Mechanism, designed to deliver greater
centralised supervision of major banking institutions in the
eurozone, is a done deal.
Still, although progress has been achieved, four main doubts
linger on: social stability, cyclical versus structural change,
Millions of persons
Percent of GDP (%)
6
distrust of inter-government agreements and over-reliance on
the European Central Bank (ECB).
12
10
8
6
4
2
0
‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13
Surplus countries: Austria, Belgium, Finland, France,
Germany, Luxembourg, Netherlands
Former deficit countries: Cyprus, Estonia, Greece,
Italy, Ireland, Malta, Portugal, Slovakia, Slovenia, Spain
Source: Eurostat as of 17 October 2013
Although external trade balances in the periphery have
improved since the height of the global credit crisis due to
a cyclical contraction in domestic demand, we do not yet
know whether growth models in these countries are
changing structurally. It takes time for labour and capital to
shift from unprofitable to profitable sectors, and from
non-tradable sectors to exports. So the question remains
whether these countries are able to grow and maintain their
external surpluses.
EUROPEAN PERSPECTIVES | DECEMBER 2013
3
At the same time, investors have little evidence to trust
policymakers to do what the rule book says. Member states
– Germany and France in particular – broke their budget
promises under the eurozone’s Stability and Growth Pact,
while the no bail-out clause was broken. It is doubtful
whether new inter-governmental agreements will be effective
without assigning cross-border powers over national budget
and economic policies to the European Parliament or a senate
representing the eurozone countries.
Status quo PLUS
In a monetary union, individual countries’ fiscal policies and
labour markets need to be all the more robust to make up for
the loss of exchange rate flexibility. This means even higher
primary balances and more flexible labour markets are
prerequisites for stability. Throughout history, no monetary
union has survived without either transforming into a
complete political and fiscal union or eventually breaking up.
Markets are therefore too complacent if they think the
stability purchased by the ECB will last forever.
Investment implications are two-fold: The political will behind
the euro is strong enough such that redenomination risk from
the euro to legacy currencies is de minimis. Status quo and
federalist policies are likely to come closer together over time.
First, we believe the risk for government and corporate bonds
with maturities of up to three years that sit under the
umbrella of the ECB’s pre-committed liquidity policies to be
low and may therefore serve as an attractive basis for
participation in periphery country assets. And second, for
securities with longer maturities and lower down in the
capital structure, caution is required as with all riskier assets.
Sovereign debt restructuring in Greece and growth
headwinds put question marks on the sustainability of
Portugal and Italy’s debts. But given the structural
adjustments that are occurring, bank bail-in rather than
bail-out and the possibility of status quo PLUS policies as a
backup, today’s price levels already compensate investors for
taking some additional risk.
Nevertheless, muddling through looks set to continue in the
next legislative period of the European Parliament. The status
quo faction will seek to exploit the untapped potential of
European treaties. The European Council will appoint the next
president of the European Commission, taking into account
the results of the upcoming European Parliament elections,
thereby increasing the democratic legitimacy of the European
Commission and binding it closer to the Council. The Single
Resolution Mechanism, an integral part of the banking union,
will be put into place and is expected to come into force by
January 2015. Greece and its public sector creditors are likely
to agree on debt restructuring by further reducing coupons
and extending maturities. And by 1 January 2018, the
European Fiscal Compact legislation will be included in the
European treaties.
4
DECEMBER 2013 | EUROPEAN PERSPECTIVES
So what if muddling through fails? The European Stability
Mechanism (ESM) has a lending capacity of €500 billion,
about three times the size of the EU’s annual budget. If
growth in the eurozone disappoints, ESM resources, with
shareholder approval, could be mobilised for countercyclical
fiscal policy. We call this the “status quo PLUS” policy that
could be activated if muddling through fails to spur growth
and stabilise sovereign debt.
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not guaranteed and will fluctuate in value.
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