Is the euro crisis over?

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It is remarkable how sentiment has turned around on Europe from where we were less than three months ago. Back then, the euro was tanking, fears were escalating that the continent would suffer a series of sovereign debt defaults, and financial contagion raged out of control. My how things have changed. The governments of Spain and Portugal, the two countries (after Greece) that gave investors the most heartburn, have been successful at selling bonds on international markets, easing concerns about their solvency. The spreads between the yields on Spanish and Portuguese bonds and their benchmark German counterparts have narrowed, meaning investors see them as less risky than before. The euro has rebounded against the dollar. Growth is holding up better than many expected.

So is it crisis over? Clearly Europe has come back from the brink of something potentially very ugly. But I wouldn’t make the mistake of unfurling the “Mission Accomplished” banner just yet. That’s because the European debt crisis was just an outgrowth of deep, underlying problems within the Eurozone – problems that have yet to be addressed.

But first, let’s give credit where credit is due. Though the concerns about cascading sovereign defaults were probably overblown – especially in the case of Spain – European leaders did do just enough to at least partially rebuild investor confidence. The $1 trillion rescue fund organized by the European Union in May definitely helped. So has talk that the EU will establish a kind of “economic government” to coordinate fiscal policies to try to avoid such debt crises in the future. More important, perhaps, were some tough measures taken at the national level. Spain’s government managed to push through not just a slate of budget cuts but also long-overdue labor reforms that could start the process of repairing a very broken job market.

But these steps were simply crisis-induced band-aids, aimed at making Europe’s leaders look serious about change while not really achieving all that much change. Spain’s labor reform, for example, is a good start, but just a start, with the general consensus (outside of the country’s stubborn unions) being that a much more fundamental dismantlement of the overly protective system will have to eventually take place if more jobs are to be created. Other countries – Greece, Portugal, Italy — will have to undertake equally difficult structural reforms to become more competitive. The “economic government” is a good idea in theory but no one is sure if the EU will have the will or the power to really enforce any restrictions on its members’ spending habits.

The EU seems to excel at the half-measure. Take the much-anticipated European bank stress tests. The exercise was a great idea in theory – increase the transparency about the health of Europe’s financial system to bolster confidence. In practice, the EU, again, didn’t go far enough, and the actual results, announced Friday, were met with instant yawns. Only seven of the 91 banks tested failed – in other words, will need to raise capital to withstand an economic downturn – raising concerns that the criteria were simply not stringent enough. Of the seven that flunked, five were Spanish savings banks, a sector everyone already knew was troubled. So in the end, the effort appeared half-hearted, and so was the response in the marketplace. The best anyone can say is that the stress tests weren’t a complete disaster. BofA Merrill Lynch commented in a recent report that the test results were “arguably a bit unconvincing,” but then added:

However, the combination of the detailed bank-by-bank debt exposure and the sizable — and untapped — bail-out fund could go a long way toward damping market concerns…The exercise itself may not have been particularly informative, but the information revealed may significantly impact sentiment. Here is a case where honesty really is the best policy.

Not everybody was so forgiving. Wolfgang Münchau of the Financial Times appears to have burst a few blood vessels venting at the soft criteria of the stress tests, especially the fact that the EU didn’t account for possible sovereign defaults:

If you tried to test the safety of cars or children’s toys using the same method the European Union applied in its stress tests on banks, you would end up in jail. How so? Simply because the testing mechanism was calibrated to fix the result. The purpose of the exercise was to ensure that the only banks that failed it were those that would have to be restructured anyway…The purpose of this cynical exercise was to pretend that the EU was solving a problem, when in fact it was not.

And there’s the point. Europe may be able to patch up investor confidence by acting like problems are getting solved without actually solving them. But that will only get Europe so far. Europe still has great disparities in competitiveness between its resident members, with big surplus nations (Germany) co-existing with deficit nations (Spain), and generally nothing is being done to actively address these imbalances. Nationalistic preferences persist that rob Europe of the full benefits of a common market. Structural and fiscal reforms will have to continue in Greece, Spain and other weaker economies, and not much is being done to ease their pain or boost their growth prospects.

What that all means is that Europe will continue to struggle to find growth. In a July update, the IMF reduced its 2011 Eurozone growth forecast to 1.3% (keeping its 2010 projection at an anemic 1%). Europe just isn’t going to get rid of its very high unemployment if it doesn’t start creating more growth. But all that sovereign debt is still around, and austerity measures needed to combat it will only really start to bite next year. Europe’s leaders may have won a couple hands with a solid bluff or two, but eventually, they’ll have to produce a royal flush. Otherwise, the euro crisis won’t ever be really over.