The battle to save the euro turns on one question: Can large governments, notably those of Italy and Spain, get their debts under control?
Because they are in a monetary union, euro members can’t take the easy way out by devaluing their currencies to make their obligations smaller and exports cheaper relative to others’. Instead, they have to make painful budget cuts and slash workers’ wages to restore their competitiveness—moves that, in the short term, can make their debts less manageable by eroding economic growth. If the belt-tightening proves too much to bear, or if the markets lose faith in the governments’ ability to succeed, the euro area will break apart.
Europe’s leaders can take credit for making considerable progress in containing market panic and demonstrating their commitment to the currency. They have pledged to share responsibility for overseeing and shoring up euro area banks, potentially relieving struggling governments of a big liability. More important, the European Central Bank has promised unlimited support to keep countries’ borrowing costs in check, as long as they act in a fiscally responsible manner.
So how much has all the activity achieved? One way to judge a sovereign’s finances is to compare its current fiscal challenges to what it has achieved in the past. We did so by measuring the difference between two numbers for Italy and Spain: The first is the largest primary budget surplus (excluding interest payments) the government has maintained for any 10-year period in the past few decades; the second is the primary surplus it must achieve to ensure its debt burden doesn’t grow faster than its economy. If the first number is larger than the second, history suggests the government’s debts are manageable. The answer can change from day to day—minute to minute, even—along with market interest rates and the country’s economic outlook.
The results are both encouraging and daunting. Crucially, the ECB’s open-ended bond-buying program, announced on Sept. 6, has calmed markets enough to bring Spain and Italy back from the brink (see chart). As recently as July, high borrowing costs had pushed both sovereigns into insolvent territory. As of Oct. 12, with the yield on its 10-year bond down to 5.6 percent, Spain could squeak by with a primary budget surplus of about 1.3 percent of gross domestic product, just below its maximum 10-year historical average of 2.1 percent. Italy, which has a larger debt burden, would have to run a surplus of 2.3 percent to get over the bar. It is on course to best that number this year.
Now for the daunting part. While financial health may be within reach, many of Europe’s governments—Spain’s in particular—have a long way to go. The International Monetary Fund estimates that Spain will run a primary budget deficit of 4.5 percent of GDP this year. To get to a surplus of 1.3 percent, the country still needs to cut spending or raise tax revenue by almost 6 percent of GDP. With Spain’s economy already shrinking, unemployment at 25 percent, street protests gaining momentum, and Catalonia threatening to secede, it is hard to imagine how the government can inflict more austerity and hold the country together.
Spain’s difficulties demonstrate why Europe’s leaders must think beyond the deficit-cutting measures that have been their central solution to the euro’s ills. Economists have long argued that, for the currency union to survive, the euro area needs a system of mutual support that can help its members through tough times, much as federal tax credits and other payments in the U.S. offset about 30 percent to 40 percent of any economic slump in an individual state. Such a transfer union need not be extortionate: Our calculations suggest the average annual cost to Germany would be in the hundredths of a percent of GDP.
Europe also needs to move quickly on other risk-sharing mechanisms, such as the banking union that leaders agreed to in June. Germany lately has shown a reluctance to help recapitalize the euro region’s banks. In its latest Global Financial Stability Report, the IMF warned that if policymakers delay, the resulting shrinkage in bank lending could severely deepen the recessions in the euro zone’s most vulnerable countries.
Three years after the first rumblings of sovereign-debt troubles in the euro area, its leaders are beginning to get a grip on what has become a defining crisis for the entire European project. Lest their progress be wasted, they will have to do a lot more to forge a deeper union.