The deal reached on the euro-zone will contain the contagion from spreading, but with low economic growth and debt rising in Italy and Spain, Europe has merely bought time.
Europe buys time, but major restructuring is still needed
In the early hours of yesterday morning, Europe's leaders claimed victory in the battle to save the euro zone. They clinched a comprehensive deal that halves Greece's debt and quadruples the firepower of the bailout fund to about $1.4 trillion (Dh5.1 trillion). For now, that will contain the contagion spreading from euro-zone periphery countries to the core and the rest of the world, which has threatened to plunge the global economy back into recession.
But with low economic growth and rising debt in major economies like Italy and Spain, Europe has merely bought time. Over the next year, the focus will have to shift from the banking and sovereign debt crisis to the growth and competitiveness crisis that is at the heart of the euro-zone's turmoil.
Europe had to calm market fears and finally show some leadership amid growing uncertainty. After 18 months of procrastination and incremental steps, the breakthrough came at 4am in Brussels, where euro-zone countries had been locked into marathon negotiations with banks and the International Monetary Fund. In a 15-page end-of-summit communiqué short on detail, the leaders agreed to restructure Greek debt, recapitalise banks and recalibrate the euro-zone bailout mechanism.
First, Athens will effectively receive a new $140 billion bailout, the third since the crisis broke in early 2010. That money will come from holders of Greek debt converting their existing bonds into new loans at preferential rates. Investors have accepted a loss or "haircut" of 50 per cent, which is more than double what was agreed in July 2011. An extra $40 billion will be provided by euro-zone governments. In turn, the Greek government has pledged to reduce debt to about 120 per cent of national output by 2020, down from 160 per cent at the moment. On current projections, it could peak at 186 per cent next year.
Second, to avoid a protracted banking crisis, Europe's banks that are exposed to sovereign debt will have to comply with a new 9 per cent capital ratio by July 2012. That will involve raising extra capital worth about $140 billion.
Third, the strength of the euro-zone bailout mechanism will be boosted by insuring the losses on national bonds. That will be combined with partial guarantees for special purpose investment vehicles, designed to attract money from the sovereign wealth funds of emerging markets in Asia and the wider Middle East.
Will it work? Much depends on the detail that will be worked out in the coming weeks. But the agreement does tackle the combined sovereign debt and banking crisis, which has been allowed to fester for far too long. The logic of the deal is for investors and countries to accept more pain now in exchange for protection against future market turmoil.
If exposed banks cannot raise additional capital on the international markets, governments will step in. That should shield the banking sector against losses resulting from any government default. The trouble is that the expanded bailout mechanism lacks the necessary strength to eliminate contagion from Greece to Italy or Spain. Market fears over Italian and Spanish debt are currently compounded by political uncertainty. The Berlusconi government is close to collapse, and Spanish elections are delaying economic reform.
In this context, foreign investment in the euro-zone bailout mechanism would provide a welcome boost. Earlier this month the BRIC countries indicated that they might "help Europe". Last week Qatar signalled that it could purchase stakes in euro-zone banks and other depressed assets. The Qatar investment authority is estimated to control about $70 billion and seeks to diversify its holdings. It has already bought into Greek banks and a mining company. Now that a debt deal has been reached, the euro-zone can expect to bring in more money from emerging market sovereign wealth funds. Qatar's Prime Minister Sheikh Hamad Al Thani indicated as much at the World Economic Forum in Jordan last week. The French President Nicolas Sarkozy and EU officials will travel to Beijing next week for talks with potential investors.
But even if Europe gets on top of its debt and attracts more foreign investment, the euro-zone crisis won't go away. That's because the sovereign debt and banking woes are mere symptoms of a much more fundamental problem - huge imbalances between surplus and deficit countries that are fuelled by a growing competitiveness gap.
The surplus countries in the euro-zone core such as Germany, France, the Netherlands and Finland have kept wages low in order better to compete in the global economy. But there is a downside of their virtuous behaviour, as they export mainly to the rest of Europe. Without the possibility of devaluing their currencies, the deficit countries in the euro-zone periphery such as Greece, Ireland or Portugal need to enact painful reforms to bring down wages and prices. Over time, the social costs of economic austerity are politically unsustainable.
So what is to be done? To reduce the rising imbalances, the euro-zone core needs to boost wages in line with labour productivity growth. In that way, workers get properly remunerated and can consume more, which will benefit the countries in the euro-zone periphery. To raise productivity in structurally disadvantaged member-states, the EU should bring forward structural and regional aid that has already been earmarked in the Union budget. By some estimates, these untapped funds could be worth over 9 per cent of Portugal's national output and 7 per cent in the case of Greece.
In addition, the euro zone must create euro bonds that would allow the periphery countries to borrow at less usurious interest rates. This, coupled with greater coordination and oversight, would put public finances on a sustainable footing.
Finally, the EU as a whole must expand investment in strategic sectors, for example via union bonds that would pool public and private funds. For once the cliché really is true: exceptional times call for exceptional measures.
Adrian Pabst is lecturer in politics at Britain's University of Kent and visiting professor at the Institut d'Etudes Politiques de Lille, France