So much for a quiet Christmas in the euro zone. The European debt crisis has been off boil for the past several months, but we all knew it was just a matter of time before the steam started rising again. The question was: What would turn up the heat?
I would have put my money on Spain stumbling into a bailout program, but instead the spark has come from one of the key figures in the euro zone: Italian Prime Minister Mario Monti. The respected economist surprised financial markets on Saturday when he announced he would step down early, after the latest budget passed through Parliament. Italy watchers had assumed he would stay on until fresh elections took place in the spring, but now that poll will likely take place earlier in 2013. Immediately, the debt crisis sprung to life. Yields on Italian 10-year bonds jumped on the news. They are still well below the more dangerous levels reached over the summer, but the negative reaction from investors to Monti’s decision tells us quite a bit about the course of Europe’s debt crisis.
Investor concerns make perfect sense. Monti, a former E.U. commissioner, has been one of the most important individuals in Europe’s quest to resolve its debt crisis. In his year in office, Monti managed to pull Italy back from the brink of an ugly tumble, possibly into a bailout or default. He was ushered in a year ago by political parties who realized they needed a technocratic outsider, with limited political interests, to push through the reforms necessary to avert disaster. He quickly lived up to expectations, short-circuiting the usually fractious political process to ram though an austerity budget and a liberalization of Italy’s professions. After months of heated debate, he also managed to get a reform of Italy’s convoluted labor laws enacted, which aims to encourage hiring and ease restrictions on downsizing. Monti was also a loud voice for the struggling economies of the euro zone in summits with the often inflexible leaders of Europe’s stronger, Northern economies, like Germany’s Angela Merkel. In playing this role, Monti was able to quiet concerns about Italy’s economic future and thus drastically bring down borrowing costs. Talk that Italy would require a costly bailout subsided.
There are those analysts, though, who contend Monti’s tenure was overrated. The labor reform, for example, was watered down from the tougher original plan to appease unions and convince the Parliament to approve it. His budget-cutting policies also helped Italy sink into recession. Here’s what the always cheerful Wolfgang Munchau of the Financial Times had to say about Monti’s record:
The Monti magic seemed to work for a while — much longer than I had expected. The yields on Italian 10-year bonds dropped about 200 basis points during his term because investors, desperate for good news, wanted to believe the magic. But Mr. Monti’s year in office has been a bubble, which felt good for investors while it lasted but has deflated. And it will probably take Italians and foreign investors not all that long to realize little has really changed over the past year, except that the economy has fallen into a deep depression.
Still, there is little doubt that Monti was seen as one of the good guys, at least trying to get things done in a country where getting things done isn’t all that easy. In his wake, he leaves a much more muddled political scene. The cartoonish Silvio Berlusconi, who was forced to resign last year as the economy went into meltdown, is talking up a return and criticizing Monti’s reforms to launch this comeback. The result of all this is that Italy — and thus the euro zone — could be headed for another period of financial instability. Here’s research firm Capital Economics from a Dec. 10 report:
The intended resignation of Italian technocrat Prime Minister Mario Monti is a timely reminder that the euro-zone debt crisis still goes way beyond the problems of Greece … It was only ever a matter of time before worries over Italy’s position re-emerged. After all, despite some optimism over the structural economic reforms put in place by Monti’s government, the economy’s performance has continued to be very poor indeed … We stick to our long-held view that Italy will need to undertake a substantial debt restructuring (i.e. default) at some point if it is ever to return its public debt to a sustainable level. Against this background, it would be no surprise if the renewed upturn in Italian bond yields goes much further, and doubts over Italy’s long-term future inside the single currency re-emerge.
Such fallout from the departure of one person from the 17-nation euro zone tells us a lot about the current state of affairs within the monetary union. Though the turmoil has receded in recent months, it is not due to any meaningful structural change within the euro zone, or improved economic prospects. The attempts to strengthen the governance of the monetary union are proceeding only slowly (still no eurobond, still no fiscal union, still no banking union, etc.). And the economy, burdened by austerity measures and uncertainty, has sunk into a serious recession, with zonewide unemployment hitting record after record. Nor is there much confidence that reform can continue within euro-zone members. Will the next Italian Prime Minister (assuming it isn’t Monti), pick up the reform drive where Monti left off? Maybe, but probably not with the same zeal. What this all means is that the improved sentiment in the euro zone has not been due to any underlying fundamentals or institutional strength, but the actions of a few, devoted people. As soon as one of those people departs the stage, the old concerns and turmoil returns instantaneously.
The reaction to Monti’s exit also shows the limits of the ability of the European Central Bank (ECB) to quell the crisis. A big reason why markets in Europe have been so calm in recent months is ECB President Mario Draghi, whose inventive bond-buying program, revealed in September, put the powers of the central bank behind financial stability in Europe as never before. However, Draghi and his program can’t fix individual economies or improve their debt position. Ultimately, Draghi needs politicians like Monti to repair the euro zone and ensure the future of the monetary union. The central bank, powerful as it might be, can’t achieve that on its own.
Lastly, Monti’s record also shows us the failings of the entire approach to the euro-zone debt crisis. After a year of Monti’s reforms, Italy is not in a much better position economically. Sure, the reforms Monti has introduced will take a while to kick in and boost growth. That’s why in the short term there needs to be more flexibility in policymaking. The austerity-obsessed approach to the crisis continues to weaken already weak economies and make debt and deficit targets harder to achieve.
The ultimate lesson behind the Monti story in Italy is that despite his best efforts and some reform victories, in the short to medium term Europe’s economic health and its debt crisis have not fundamentally improved. It takes more than one man, no matter how capable, to make that happen.