The eurozone stumbles along

Today, we turn to risk #3 in our series of posts on Eurasia Group’s Top Risks for 2012 and answer the most common questions we’ve gotten about it.

Here’s a summary:

Eurozone- The Muddle is the Risk. In Europe, it’s not the breakup of the eurozone we need to fear in 2012 but a reactive, incremental approach to crisis management that will fail to satisfy investors and could push events beyond the control of political officials. The uncertainty and volatility we saw in 2011 has only just begun.

Q- Why can’t European leaders solve this problem? Isn’t it simply a question of collective political will?

A- There are many reasons why a grand bargain-style comprehensive fix is not going to happen. First, there is no common understanding of why this crisis is happening. Some say that the so-called peripheral countries — Greece, Ireland, Portugal and Spain — have failed to live within their means and now need Europe’s stronger economies to bail them out. Others say that the divide between debtor and creditor nations has gotten too wide, and that countries like Germany, which has the second largest trade surplus in the world after China, are part of the problem. Still others say that the eurozone was doomed from the beginning by a governance system that allows for a common monetary policy but separate fiscal policies for each of its 17 members.

And it’s in the interests of these players to disagree about the nature of the problem, because no one wants the lion’s share of responsibility for solving it. Peripherals don’t want core countries telling them how much to tax and spend. Core countries don’t want to have to bail out less competitive economies. The European Central Bank (ECB) doesn’t want to promise to backstop these problems for fear that it is mixing fiscal and monetary policy functions, and that any help it provides will allow governments to delay or avoid much needed structural reforms.

This is why the various leaders will do just enough this year to keep things from completely falling apart, but not much more. Peripheral countries will swallow the medicine of austerity, but they will continue to demand that sacrifice be shared. German Chancellor Angela Merkel’s government will do enough to keep Europe intact, but not so much that her party’s coalition partners and German taxpayers believe she has put Germany on the hook to bail out spendthrift countries whenever they get in trouble. The ECB will claim that its mandate does not include a guarantee against eurozone failure while working behind the scenes to help struggling governments stay afloat.

Finally, this is a complex problem, one that requires systemic changes to the eurozone itself. These changes will have to be negotiated and will take considerable time to implement. Much more than a few months.

Q- Then why are you confident that the eurozone won’t simply collapse? If long-term confidence isn’t restored, isn’t it possible that markets will sink some eurozone members and break up the whole game?

A- That’s a risk, but only a small one for 2012. No European government wants to see the euro go away. The single currency has allowed Germany to run up those large surpluses without the currency pressures they would face without it. The Greeks know that if the country leaves the euro, the value of its new currency would fall quickly — while any debts it agreed to pay would still be denominated in euros. Default would wipe away some of the debt, but Greece can’t walk away from all of its sovereign and corporate obligations. More than 70 percent of Greeks tell pollsters that they support their country’s continued membership in the eurozone. And let’s not forget that countries across Europe have invested tremendous hope and pride in the larger European idea. That’s a hard thing to measure, but it’s a crucial factor in Europe’s cohesion.

Q- What’s so dangerous about more "muddle through?"

A- There is going to be more market volatility in Europe this year, and growth across the eurozone will be painfully slow. Recession appears likely. Slower growth will make problems tougher to resolve, because all of the key negotiators will face greater pressure at home to drive a hard bargain with other governments and institutions. That’s true for the core countries and the peripherals, particularly on issues that require ratification by domestic parliaments or public support expressed in a referendum. Adoption of the so-called European Stability Mechanism, essentially a crisis fund for governments in trouble, and establishment of a more tightly coordinated area-wide fiscal policy are the most obvious examples.

The broader risk is that half-measures will allow the eurozone to stumble along without its leaders ever really tackling the underlying problems. The peripheral countries need to change their behavior. Getting Greece back on its feet and restoring confidence in the balance sheets of larger countries is also crucial and will demand more than the incremental solutions currently in play-especially if its debt stock is to be made sustainable. But market confidence in the eurozone’s long-term stability can’t be fully restored without fundamental change to the design of the entire system.

Next up, the U.S. risk that no one is talking about. Yet.