Eurocrisis: method in the madness?

Good news is getting more airplay these days. It’s a great relief, following years of gloom, and this time, perception seems well-anchored in actual data. It’s doubly encouraging that economic improvement is occurring in spite of persistent nagging headwinds. However, it’s too early to dismiss the key risks the world faces – taking our eyes off them could be fatal.

Which risks top the list? The US fiscal cliff is perhaps the most imminent threat. Less mentioned is Japan's looming debt crisis, but it's arguably a much larger medium-term growth obstacle. Slowdown in emerging economies has wreaked havoc with already-frayed nerves. Commodity price volatility hasn't helped, and political turmoil in the Middle East has added to the nail-biting. Complicating the situation is low confidence, which ensures overreaction to every negative development.

That’s a daunting list, but for size, imminence, potential impact and likelihood of occurring, Europe’s sovereign debt crisis is still the top global risk issue. The Eurozone still faces a number of critical dates in the near term, all the while battling a region-wide recession that is well underway. Given that the Zone commands about 20 per cent of global GDP, all eyes are on the policymakers on the front lines of these repeated challenges. Will they continue to keep the region on the up-and-up?

Recession isn’t helping – but it’s also true that policymakers ostensibly decided to have a recession. The total agreed fiscal withdrawal last year and this on average has exceeded Eurozone potential growth – the negative numbers we now see were all but inevitable in the plans crafted in the wake of the extraordinary post-crisis stimulus measures. Will Europe – and the world – survive the weak spot?

Every critical date is a potential tipping point for the world economy. Failure to agree on measures to address the next critical debt-date – regardless of the nation in question – would threaten the world with a contagion effect with very serious consequences. Many have called for a more permanent solution than going event-to-event, arguing that the Zone only has so much policy runway. It’s a possible remedy, but it might also be argued that the time for a “shock and awe” solution has long since passed. Perhaps policymakers are now confined to one-off solutions. Could they suffice?

Possibly. As haphazard as the process may seem, a pattern is emerging in Europe’s approach to its debt problems. With each looming critical date, financial market concern rises to a peak, driving bond spreads sharply higher. Market turmoil then motivates the parties at the table to negotiate, and in each instance, brinksmanship has given rise to ever-more-creative workable solutions. In each of the many cases to date, crisis has been averted by this process – so much so that it can now be called a trend. While disconcerting, the track record of this bizarre process is surprisingly good.

Two enablers are key. First, US-led momentum needs to continue. Second, the worst of Europe’s deep fiscal cuts are behind it. As successive cuts diminish rapidly, Europe will actually see a growth dividend. That point is actually much closer than most seem to believe.

The bottom line? However chaotic Europe’s policy arena appears, there is a pattern to the policy path that is seeing the Zone through its worst days, and may be paying dividends sooner than expected.

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