The prospects for the euro and the eurozone remain uncertain, but recent events at the European Central Bank (ECB), in Germany and on the global financial markets make it worthwhile to consider a favorable scenario for the common currency’s future.
The ECB has promised to buy Italian and Spanish government bonds to keep their interest rates down, provided these countries ask for lines of credit from the European Stability Mechanism (ESM) and adhere to agreed fiscal reforms. Germany’s Constitutional Court has approved the country’s participation in the ESM and German Chancellor Angela Merkel has given her blessing to the ECB’s bond-buying plan, despite strong public objections from the Bundesbank. The international bond market has expressed its approval by cutting interest rates on Italy’s 10-year bonds to 4.8 percent and on Spain’s to 5.5 percent.
Italian bond rates had already been falling before ECB President Mario Draghi announced the conditional bond-buying plans. That reflected the substantial progress Italian Prime Minister Mario Monti’s government had already made. New legislation will slow the growth of pension benefits substantially and the Monti government’s increase in taxes on owner-occupied real estate will raise significant revenue without the adverse incentive effects that would occur if rates for personal-income, payroll or value-added taxes were raised.
Reflecting these reforms, the IMF recently projected that Italy will have a cyclically adjusted budget surplus of nearly 1 percent of GDP next year. Unfortunately, because Italy will still be in recession next year, its actual deficit is expected to be 1.8 percent of GDP, adding to the national debt, but economic recovery will come to Italy, moving the budget into surplus.
When the markets see that coming, they will drive Italy’s sovereign interest rates even lower. Given Italy’s very large national debt, interest payments add more than 5 percent of GDP to the fiscal deficit.
The combination of economic recovery and lower interest rates would produce a virtuous dynamic in which falling interest rates and a rising budget surplus are mutually reinforcing.
The situation in Spain is not as good.
Despite cuts in government spending and increases in taxes, the IMF still projects the cyclically adjusted fiscal deficit will exceed 3.2 percent of GDP next year and 2.3 percent of GDP in 2015.
The key to solving Spain’s fiscal problem lies in the semi-autonomous regions that generate spending and shift the financing burden to Madrid. Perhaps Italy’s success will help to convince Spain to adopt the tough measures that reduce projected future deficits without more current austerity.
If Italy and Spain have budget surpluses and declining debt/GDP ratios, financial markets will reduce the interest rates on their bonds without the proposed ECB purchases. That would remove the serious risk that the ECB could start buying bonds on the basis of agreed fiscal packages and then be forced to react if governments fall short on implementing them.
None of this would be enough to save Greece, where the fiscal deficit is 7.5 percent of GDP, or Portugal, where it is 5 percent of GDP.
However, if Italy and Spain are no longer at risk of default, or of abandoning the euro, Germany and other eurozone leaders will have room to decide whether to continue funding these very small states or politely invite them to leave the euro and return to national currencies.