What the Eurozone needs to do in the long term

23rd April 2013

Keith Wade, chief economist at Schroders has put together an assessment of the near term cyclical challenges and considers what the Eurozone needs to do to ensure its long term viability. Among other things, Wade assesses the merits of Europe wide bonds and a banking union.

Divergence rather than convergence

Eurobonds

Banks and Sovereigns

Conclusion

As the euro crisis has evolved, it has become increasingly apparent that Europe makes progress through a series of crisis. Only when faced with the prospect of the system breaking down do we discover what is a non-negotiable line in the sand from a bargaining position. As financial markets have found, brinkmanship is an integral part of politics and hence the resolution process.

However one of the side effects of the ECB’s policy of flooding the markets with liquidity (actual or threatened) and reducing market volatility has been to reduce the risk of a crisis. Peripheral bond spreads have continued to tighten as investors hunt yield, believing that the ECB stands behind them. Clearly such action has created a much needed breathing space for the euro, but by removing the danger of crisis it has taken the pressure off governments to take action.

Germany and the other core countries (Benelux, Finland and France) have benefitted from the trade gains created by the single currency and are now benefitting indirectly from the crisis through extraordinarily low levels of interest rates. According to Deutsche Bank, Dutch government bond yields are at their lowest for 500 years. The route to a sustainable euro will involve persuading the core to give up some of these gains on rates for higher growth and a stable euro over the medium term.

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