Risk of Grexit and QE: the end of the Euro or the start of better times?

By Prof Dr. Freddy Van den Spiegel (Professor Free University Brussels and Vlerick Business School; European correspondent FCIB)

While the US seems to have completely recovered from the financial crisis in 2008, the European Union remains in the doldrums. Especially the Eurozone is characterized by low growth, fear of deflation, a still crippled banking system and weak governments. Recently, two European topics have dominated the news headlines: a QE program launched by the ECB, and a potential Grexit scenario in which Greece would leave the Eurozone. Both seem to be desperate jumps into the unknown and towards complete chaos. Or are these “problems” part of the solution?

The financial crisis started in 2008 in the US, because of an overheated housing market, combined with very complicated and sometimes fraudulent financial products. It seems strange that the European economy still struggles, while the crisis seems to be fully digested by the US. There are at least three factors explaining this divergence.

First of all, the monetary policy after the crisis brake out was far more aggressive in the US than in the Eurozone. Quantitative easing, the central bank creating money to buy government bonds, took off in the US in 2009. The ECB only starts now with such a program, because the legal framework for monetary policy in the Eurozone is far more restrictive. Given the positive effects of quantitative easing in the US, one could say that the ECB has lost 5 precious years, but is now doing what is needed.

Second, the EU has proportionally far bigger banks than the US which makes a banking crisis more difficult to manage and digest. Furthermore these European banks are all intensely linked their home country, a single member state. The insolvency of one big bank that has to be rescued can ruin a country. The start of the banking union in November 2014, with the ECB as single supervisor and a European fund to rescue banks in trouble has reduced that risk, and banks are far more solid.

Third, with the creation of the Monetary Union, the member states of the Eurozone took all the advantages of the new strong currency in terms of lower interest rates, but refused to streamline their economic policies, leading to excessive debt levels and lack of competitiveness in some countries such as Greece. In the new framework, the European Commission has the power to punish member states with excessive imbalances.

But in the meantime, irresponsible behavior of some member states has led to a political crisis of the Eurozone in 2011, which was almost fatal. That risk has been countered by the ECB, launching its first “bazooka” in July 2012, when governor Draghi claimed that the ECB would do “whatever it takes” to rescue the euro. And now, Draghi has launched a Quantitative Easing plan, injecting every month 60 billion Euro in the economy, until a total amount of 1.000 billion € is reached. Simultaneously, the European Commission has launched the idea to create a European Capital Market and to stimulate long term investments with the support of the European Investment Bank

Without any doubt, everything is not perfect in the Eurozone, and much has still to be improved, but it must be recognized that most of the structural weaknesses of the zone have been tackled and that the situation improves gradually.

Today, the risk of Greece leaving the Eurozone is not leading to panic anymore. It is considered as one of the possible options, and markets are almost not reacting on any news in that direction. Even high level German politicians consider it as a realistic, be it not preferable way out. And this reduces the capacity of the New Greek government to blackmail the Union. Continuing the bail-out program of Greece by Europe and the IMF until June was only approved after Greece promised to continue to implement the structural reform program. Greece is now expected to come up with a realistic new reform program in order to get further support after June. Tough and difficult negotiations with lots of arm wrestling will be unavoidable but ultimately, I would guess that an agreement will be found, easing somewhat the austerity measures and giving Greece more time to bring its house in order. If an agreement according to these principles proves to be impossible, Grexit becomes an option. That would be bad but not fatal for Europe, while it could bring Greece into economic and political chaos. While this could create political tensions in some other Eurozone countries, it is highly unlikely that other member states are willing to copy a Grexit scenario.

Europe desperately needs growth to restore confidence and popularity among its citizens. The continuous threat of Europe getting into a “Japanese” scenario with decades of slow growth and deflation is undermining the moral. The possibilities of Grexit and close to zero interest rates given QE are certainly not helpful in that respect. And the situation in the Middle East, combined with the conflict between Russia and Ukraine are equally contributing to pessimism and fear. But more positive news could be coming in the next few months.

The recovery in the US, combined with lower interest rates in Europe have already reduced the value of the Euro/dollar with about 20% over the last 6 months. That has nothing to do with “currency-wars”, but is the automatic and welcome result of the different outlook in the two regions. For years, the US has profited from an overvalued Euro, but now, the Eurozone is getting more competitive thanks to the lower value of its currency. And this helps. Almost all Euro countries have a net surplus on their current account. The surplus of the total Eurozone is 2,5% of GDP, and each of the four PIGS-countries (Portugal, Ireland, Greece and Spain) has a surplus.

Also lower oil prices help. It gives more purchasing power to the Euro-citizens, which can be spent in the domestic economy instead of paid to energy supplying countries. Because of the combined effect of a lower exchange rate and lower oil prices, the European commission has reviewed the growth figures for the Eurozone. While the region was growing at a meagre 0.6% in 2014, growth in 2013 would be 1,3%, and could even reach 1,9% in 2016.

Even the probability of a “Japanese” scenario seems somewhat exaggerated. Indeed the Eurozone was in deflation at the end of 2014, with a negative inflation rate of -0,2%. However lower oil prices are an important element of this result. Looking at “core inflation”, which eliminates energy price fluctuations, the level is +0,6%. Indeed this is very low, but it is far from negative. If higher economic growth can be expected, some inflation fears could come back sooner than expected.

Taking all these elements into consideration, it seems as if the possibility to get out of this prolonged European crisis is improving significantly. Of course there is no room for extreme optimism, but the problems are being recognized and tackled.

Many risks remain however. The already mentioned political situations in the Middle East and Russia are unpredictable. And the enormous amounts of money injected in the economy by all major central banks, now including the ECB, are helpful in the short term but create new bubbles which sooner or later could lead to new crises. But let us tackle one crisis at a time and hope that these new potential problems are not for 2015. Also that is a kind of optimism.

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