Return to health and reform vital to euro zone

Is the euro zone crisis over? The answer is: “yes and no”. Yes, risks of an immediate crisis are reduced. But no, the currency’s survival is not certain. So long as this is true, the possibility of renewed stress remains.

The best indicator of revived confidence is the decline in interest-rate spreads between sovereign bonds of vulnerable countries and German Bunds. Irish spreads, for example, were just 205 basis points on Monday, down from 1,125 points in July 2011. Portuguese spreads are 465 basis points, while even Greek spreads are 946 basis points, down from 4,680 points in March 2012. Italian and Spanish spreads have been brought to the relatively low levels of 278 and 362 basis points, respectively.

Behind this improvement lie three realities. The first is Germany’s desire to keep the euro zone intact. The second is the will of vulnerable countries to stick with the policies demanded by creditors. The third was the decision of the European Central Bank to announce bold initiatives – such as an enhanced longer-term refinancing operation for banks and outright monetary transactions for sovereigns – despite Bundesbank opposition. All this has given speculators a glorious run.

Yet that is not the end of the story. The currency union is supposed to be an irrevocable monetary marriage. Even if it is a bad marriage, the union may still survive longer than many thought because the costs of divorce are so high. But a bad romance is still fragile, however large the costs of breaking up. The euro zone is a bad marriage. Can it become a good one?

A good marriage is one spouses would re-enter even if they had the choice to start all over again. Surely, many members would refuse to do so today, for they find themselves inside a nightmare of misery and ill-will. In the fourth quarter of last year, euro zone aggregate gross domestic product was still 3 per cent below its pre-crisis peak, while GDP in the US was 2.4 per cent above it.

In the same period, Italian GDP was at levels last seen in 2000 and at 7.6 per cent below its pre-crisis peak. Spain’s GDP was 6.3 per cent below the pre-crisis peak, while its unemployment rate had reached 26 per cent. All the crisis-hit economies, save for Ireland’s, have been in decline for years. The Irish economy is essentially stagnant. Even Germany’s GDP was only 1.4 per cent above the pre-crisis peak, its export power weakened by the decline of its main trading partners.

If all members of the euro zone would rejoin happily today, they would be extreme masochists. It is debatable whether even Germany is really better off inside: yes, it has become a champion exporter and runs large external surpluses, but real wages and incomes have been repressed. Meanwhile, the political fabric frays in crisis-hit countries. Anger at home and friction abroad plague both creditors and debtors.

What, then, needs to happen to turn this bad marriage into a good one? The answer has two elements: manage a return to economic health as quickly as possible, and introduce reforms that make a repeat of the disaster improbable. The two are related: the more plausible longer-term health becomes, the quicker should be today’s recovery.