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The Eurozone’s shadow still hangs over us

June 22, 2013

Some three months have now passed since the dramatic Cypriot bailout. In virtually equal measure there were hopes and fears that March’s developments in one of the Eurozone’s smallest nations would be the catalyst for the endgame to the Eurozone’s travails. Rumours abounded then that Slovenia would be next in line to default.

Characteristically, however, the Cypriot skirmish appears to have been yet another storm before the lull. Economic realities have once again been relegated to their improper place as the electoral clock ticks incessantly towards late September’s Bundestag elections.

The Cypriot crisis was arguably brought to a head only because of German political imperatives. The recent emergence there of a fledgling Eurosceptic Party, Alternative für Deutschland (whose channel of communication with Tory MEPs has caused diplomatic flutters between Berlin and Downing Street) led the ever canny Angela Merkel to shore up her right flank.

Cyprus’s economy, until very recently with its Icelandic-scale financial services imbalance propped up by Russian money, was sacrificed as collateral damage in these political manoeuvres. As the attention of the financial world moves on, make no mistake, the Cypriot economy is about to plunge into tailspin. The capital controls that have been imposed on Cyprus have resulted in the evaporation of trade, business activity and growth. This in a micro-economy already absurdly overloaded with household and business debt. Almost inevitably its brightest young and middle-aged people, in a nation respected for its education system and language skills, will vote with their feet. Indeed the fanciful threat that Cyprus might soon be forced to leave both the Eurozone and the EU will only accelerate this process.

Whilst it is fashionable to blame the European Central Bank (and its German paymasters) for the crisis, this tells only a fraction of the story. For sure it monumentally mishandled the Cypriot crisis, insisting first on an unmanageable bailout and then a revised deal that was accompanied with a sense of menace against a Eurozone member widely judged as too small to bring down the whole edifice. However, amidst the chaos, some sound principles were being entrenched. Once the initial plan to seize even insured deposits was shelved, the ECB rightly imposed penalties instead on bondholders.

They have been forced to bail themselves into the rescue by a bonds-for-equity swap. Whilst in Cyprus this was insufficient properly to recapitalise its two big banks, it has set a positive precedent in the increasingly likely event that other Eurozone countries return cap-in-hand to the ECB for more assistance. If – and remember this also applies to the UK – we can begin to wean failing banks off their implicit taxpayer guarantees it will prove a very good thing indeed. The brutal truth is that even here in Britain we may soon need to follow this Cypriot precedent.

The Eurozone remains appallingly mired in debt with unsustainably large public sectors, labour-market inflexibility and excessive tax rates, all of which hinder any real chance of sustained economic growth. The enforced dragging down of labour costs in Spain, Italy and Portugal in the have immediate term helped exports. Hereby those countries have started down the road towards more competitive economies, but at the short-term price of precipitate collapse in domestic consumption, a further factor undermining any hope of their economies returning to growth any time soon.

Meanwhile, the financial markets have until now been supportive of the notion of the UK as a ‘safe haven’ amidst all this continental turmoil. Yet there is no room for complacency – deeper crises elsewhere are unlikely forever to distract investors from some of the fundamental weaknesses in the British economy. Foreign investors’ demand for gilts, a driver of the pound’s relative strength during the height of the financial crisis, peaked in November 2011. But there are some nagging fears about the UK’s progress in cutting the deficit, alongside concern about the overall state of the national debt, sluggish productivity, stagnant growth and a banking system that still seems unable to direct cash to the parts of the economy that require it. Our low interest rates and quantitative easing, by depressing the pound’s value, have also made sterling a less attractive prospect for potential currency purchasers.

In fairness there is a keen sense that the UK economy has now turned the corner, albeit steadily. Nevertheless, the continued dark clouds hovering over the UK’s single biggest export market, the Eurozone, may yet prove debilitating in the future to domestic business confidence. Even the Treasury/Foreign Office aggressive manoeuvres at export-led growth elsewhere are paradoxically being undermined – or undercut might perhaps be the better word – by those Eurozone nations being forced by extreme austerity measures to slash labour costs.

So on balance it may be unwise to give too much credence to short-term equity markets’ strength. Indeed the continued upward movement in both the FTSE 100 and Dow Jones index over the past year probably reflects only a relative upturn in business confidence rather than the general health of the UK and US corporate sector. However, the value of sterling, notwithstanding its ‘safe haven’ status, should be a warning sign of how interconnected the UK’s economic fortunes are with the travails of the Eurozone.

In such a situation, it is unquestionably difficult for the coalition government to determine the wisest, most consistent course of policy. Since it will be some time before we are able to step from the Eurozone’s shadow, this makes it all the more important to keep prospective investors in the UK happy by addressing our own vulnerabilities. In short, the Chancellor must ignore those critics demanding a change in outlook – we must press relentlessly on towards the goal of deficit reduction.