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The Eurozone’s Calm Before the Storm

NEW YORK – A little more than a year ago, in the summer of 2012, the eurozone, faced with growing fears of a Greek exit and unsustainably high borrowing costs for Italy and Spain, appeared to be on the brink of collapse. Today, the risk that the monetary union could disintegrate has diminished significantly – but the factors that fueled it remain largely unaddressed.

Several developments helped to restore calm. European Central Bank President Mario Draghi vowed to do “whatever it takes” to save the euro, and quickly institutionalized that pledge by establishing the ECB’s “outright monetary transactions” program to buy distressed eurozone members’ sovereign bonds. The European Stability Mechanism (ESM) was created, with €500 billion at its disposal to rescue eurozone banks and their home governments. Some progress has been made on a European banking union. And Germany has come to understand that the eurozone is as much a political project as an economic one.

Moreover, the eurozone recession is over (though five periphery economies continue to shrink and recovery remains very fragile). Some structural reform has been implemented, and a lot of fiscal adjustment has occurred. Internal devaluation (a fall in unit labor costs to restore competitiveness) has occurred to some extent (in Spain, Portugal, Greece, and Ireland, but not in Italy or France), thus improving external balances. And even if such adjustment is not occurring as fast as Germany and other core eurozone countries would like, they remain willing to provide financing, and governments committed to adjustment are still in power.

But beneath the surface calm of lower spreads and lower tail risks, the eurozone’s fundamental problems remain unresolved. For starters, potential growth is still too low in most of the periphery, given aging populations and low productivity growth, while actual growth – even once the periphery exits the recession in 2014 – will remain below 1% for the next few years, implying that unemployment rates will remain very high.