London, Asharq Al-Awsat- The most surprising development so far this year in the Eurozone crisis is the markets’ relative strength and confidence in the face of slow progress in resolving the Eurozone crisis, recession throughout the Eurozone and multiple sources of geopolitical instability. The Greek bailout negotiations have stalled for weeks. The Greek government appeared to reach an agreement on the latest set of austerity measures which are a precondition to the next bailout package after multiple delays, only to be rebuffed by Eurozone finance ministers and told to find further spending cuts. Negotiations on the terms of the private sector involvement (PSI) have not yet been concluded, and a potential disorderly default for Greece looms if funds are not disbursed by 20 March. Yet the Euro has not only remained resilient but appreciated since the beginning of the year, as have European equity markets. What is the basis of such optimism in the face of huge risks and uncertainty?
The ECB’s injection of liquidity is the most likely answer. On 22 December 2011 the ECB injected €489 billion of liquidity into the Eurozone banking system and government bond markets by providing 3 year loans to banks under its Longer Term Refinancing Operations (LTRO). This programme has not only provided much needed liquidity to Eurozone banks but has also supported Eurozone government bond markets by facilitating purchases of Eurozone government bonds by banks utilizing the LTRO to purchase government bonds. The ECB is due to provide another LTRO facility to Eurozone banks at the end of this month. More than anything else, this wall of money has supported the Euro and the Eurozone markets so far this year. The Bank of England has also kept open the liquidity taps, adding £50 billion this week and taking its quantitative easing programme to a total of £325 billion.
Of course the ECB’s LTRO facility is not a solution to the problem. At best, it can prevent the crisis from worsening and provide a favourable environment in which to address the underlying problems. Current favourable market conditions are not sustainable without significant progress in addressing the underlying structural problems.
In the context of bailouts and austerity programmes, public and political backlash is gathering strength. In Greece, austerity measures have been met with widespread strikes and civil unrest. Although not in the Eurozone, Romania has lost its prime minister as a result of public discontent with austerity measures required under its own €20 billion bailout package agreed with the IMF and the EU in 2009.
Beyond the public reaction to the immediate pain of austerity, insufficient attention is being given by policymakers and commentators alike to the lasting damage that some of the austerity measures can cause. Clearly, cuts in government spending and increases in taxation will have a negative impact on aggregate demand, a most unwelcome consequence during a recession. In addition to the immediate macroeconomic impact, injudicious taxes or spending cuts can have longer term impacts on competitiveness. In Romania, for example, the government brought in a claw-back tax which retrospectively taxes the pharmaceutical industry from 2010. Although an easy way to raise revenue from an industry which relies on the government for a large portion of its revenue, this discriminatory and retrospective tax will damage the attractiveness of Romania for the pharmaceutical industry. Business Monitor International commented that this tax lowered the attractiveness of Romania as a destination for drug makers from 3rd to 7th in Central and Eastern Europe. This short term revenue raising solution will cause long term damage to Romania’s competitiveness and inward investment.
The current approach to the Eurozone crisis will continue to be tested at three levels. First, the public markets will determine when and at what levels peripheral Eurozone governments can borrow. The ECB may be able to help by providing liquidity, but no solution will be able to go against the will of the markets for long. Second, public reaction will test and in some cases revoke their government’s mandate to pursue and implement austerity programmes. The Greek government may find this to be the case in the upcoming April elections, as may the Italian government in elections next year. Finally, in the longer term a number of damaging measures, such as the Romanian claw-back tax, may come back to haunt the governments that imposed them for the sake of short term expediency.