Europe's crisis is morphing again -- for the third time in only 12 months -- and the implications for the global economy are even more complex, unsettling, and troubling.
- By Mohamed El-Erian <p> Mohamed El-Erian is CEO and co-chief investment officer of investment management firm Pimco and author of When Markets Collide. </p>
Europe entered the year with an acute emergency in the periphery of the eurozone, the European Union’s elite 17-member club that shares a common currency. Misdiagnoses and inadequate policy responses allowed the contamination to travel sequentially from the outer reaches of the zone (Greece, Ireland, and Portugal) toward its inner core.
In this first of three morphings in 2011, Italy and Spain were disrupted as interest rates soared, turning liquidity concerns into solvency ones. France was then impacted, with its AAA rating threatened by its exposure to the neighborhood’s problems. Then Germany, Europe’s strongest economy and the one that everyone looks to for a solution, had to contend with the embarrassing failure of a highly visible government debt auction.
A sovereign debt crisis is bad news for anyone with large holdings of government bonds. As European banks are the largest such holders, they quickly found themselves losing the confidence that is so central to the normal functioning of any financial system.
Credit lines were cut, making too many banks heavily dependent on European Central Bank financing for raising the liquidity they need for daily operations. Equity prices collapsed as investors worried about bank profitability, thereby limiting the scope for injections of new capital. To make things worse, some depositors got nervous.
This series of events led to the second 2011 morphing of the European crisis. Having entered the year on the receiving end of the sovereign debt crisis, banks evolved into becoming a stand-alone source of disruptions — most acutely in the periphery, but also in some core countries. Suddenly, banks were in the grips of the threatening trio of liquidity strains, capital inadequacy, and concern about asset quality.
The alarm bells in European capitals rang even louder, prompting a subtle change in the policy emphasis. It was no longer just about saving the eurozone’s periphery. It became ultra-important, to use French President Nicolas Sarkozy’s words, to "refound" Europe.
As the crisis got bigger, Germany and France decided to dispense with the niceties of collective European deliberations and essentially specified the steps needed to strengthen the EU’s fiscal and institutional core. These measures found support, but not unanimous agreement.
At the highly anticipated December summit of European leaders in Brussels, German Chancellor Angela Merkel and Sarkozy failed to overcome fierce opposition from British Prime Minister David Cameron, who decided to veto the proposed treaty changes, essentially removing Britain from the constraints of enhanced European governance. With Britain providing a demonstration effect, four other EU countries expressed discomfort in the week following the summit.
This was the catalyst for the third 2011 morphing of the European crisis. Europe now found itself facing an even bigger problem — namely, a crisis of the 27-member EU as a whole. Questions multiplied as to the stability and ultimate viability of a multispeed EU.
These three distinct morphings have surprised many. They should not have. After all, the underlying dynamics are not that different from what many emerging economies have experienced in the past. Economists describe this as "path dependency." It is a process of "multiple equilibria" in which each successive outcome takes you even further away from the initial starting point.
While familiar to emerging economies, these dynamics are very different from what Western countries are used to. Specifically, for the West, it is no longer about economic cycles that involve temporary and reversible deviations from a familiar anchoring mean. It becomes a secular phenomenon that — in a fundamental manner — speaks to structural changes, institutional mishaps, and a whole series of the unthinkable becoming facts. In the process, policy measures lose effectiveness, consumer sentiment is disrupted, and healthy balance sheets retreat to the sidelines, thereby increasing volatility and accelerating deleveraging.
This is an unfamiliar world whose complexity increases exponentially as policymakers fall further behind the accelerating path-dependency dynamics. The engineering of a rescue becomes considerably more difficult and the politics even more intricate. That’s not even counting the implementation difficulties that inevitably accompany hard policy choices.
Structural challenges require structural solutions that, usually, involve a component of immediate sacrifice for the promise of welfare enhancements down the road. This tradeoff, between short-term costs and long-term benefits, is not one that comes easily to political systems heavily influenced by the election calendar.
Long-standing social compacts are threatened for a citizenry that is already angry with what has transpired. In some cases, such as Greece, this can lead to wide-scale protests, violence, and paralyzing general strikes. Turnovers in government become the rule — it should come as no surprise that there have been so many changes in Europe already, including two countries (Greece and Italy) that have opted for unelected "technocratic governments."
These are consequential developments whose impact will be felt for years, and the latter is not limited to Europe. Virtually every country in the world is exposed.
When it comes to the global economy, Europe is systemically important for at least three huge reasons. First, it is the largest economic area in the world and, as such, an important source of demand for the rest of the world. Second, with its banks holding large claims on nonresidents, their forced deleveraging will transmit waves of credit rationing well beyond the EU. Third, by fueling volatility and uncertainty, the European crisis has a material influence on the functioning of global markets.
To make matters worse, this crisis comes at a time when the United States is struggling to regain growth and generate enough jobs. Moreover, though the large emerging economies (Brazil, China, India, Indonesia, and Russia) are much healthier, they lack both the willingness and the ability to compensate fully.
It is critical for the welfare of billions around the world that Europe get its act together now. The continent faces an increasing probability of having to navigate a fourth potential morphing in the next few months. Should it materialize, this would take one of two forms: either a disorderly and highly disruptive fragmentation of the eurozone, or the establishment of a smaller and less imperfect eurozone that has a different relationship with the rest of the EU.
Both possibilities involve yet another set of immediate disruptions for Europe and the global economy. As such, the temptation among politicians will be to avoid making any active choices. But that would constitute a huge mistake. It would further reduce their future degrees of freedom due to an even narrower set of possibilities and, with that, erode their ability to influence outcomes.
As time passes, the option of a smaller and less imperfect eurozone is becoming the only way to "refound" a union that would have the chance to stand the test of time and, thus, constitute a key component of medium-term efforts to restore global financial stability, meaningful economic growth, and plentiful jobs. It is not an absolute best, and it would be a messy process involving the risk of collateral damage and unintended consequences. Yet, when judged in terms of feasibility and desirability, it sure dominates the alternative of a full fragmentation.