Tensions surrounding the eurozone have eased markedly in the early part of 2012 following the atmosphere of crisis that persisted through the second half of 2011. There is instead a new confidence that financial and economic disaster can be averted. Several developments have contributed to this optimism, including a change of government in Italy, a large injection of liquidity into the banking system by the European Central Bank (ECB), and a 'fiscal compact' among governments. The euro itself has strengthened on currency markets, and the perception of reduced risk can be seen in lower market yields on Italian and Spanish government bonds.
This does not mean that the future of the eurozone is yet assured. The steps taken so far by governments and other bodies are, in fact, widely acknowledged to be inadequate. For months, official responses to the market mayhem - in which it was feared that Italy and Spain would follow Greece, Ireland and Portugal in needing financial rescue, with the risk of debt defaults and huge bank losses - were stumbling, and failed to instil confidence. Even after the more positive recent steps, it is commonly agreed that governments have not yet arranged sufficiently large 'firewalls' to ensure that there are adequate amounts of emergency money on hand to deal with a new funding crisis in a member country. Meanwhile, there is still considerable debate about the proper functions of the ECB. In addition, it remains to be seen whether countries that have lagged behind can improve their economic competitiveness so as to reduce imbalances within the eurozone and thus make the common currency viable for the long term.
Nevertheless, even as Greeks protest bitterly against the terms attached to their country's latest rescue package, there is no doubt that the frenzy of previous months has dissipated and that, while efforts to save the eurozone are still urgent, they can be addressed more calmly.
What changed?
The single-biggest action that took the sting out of the crisis was the ECB's offer in December to lend unlimited amounts of three-year money to eurozone banks. The first offer under its Long Term Refinancing Operation (LTRO) resulted in €489 billion being loaned to a total of 523 banks. This immediately took the financial system away from the precipice. A loan-repayment problem becomes a debt crisis because of the threat it poses to lending banks. If the problem is big enough, it threatens the health of the entire banking system. That was the situation in the financial crisis of 2008, of which the eurozone crisis is a very large aftershock. In 2008, Western banks stopped lending to each other for fear of bank failures following the collapse of the US mortgage-backed-securities market. By late 2011, a similar situation existed in Europe as markets worried that the rising borrowing costs for Italy and Spain would drive them into defaults. The LTRO, however, eliminated the possibility that sovereign debt problems could cause immediate bank failures.
The manner of the ECB's intervention was unexpected. For months, there had been calls for it to fire a 'big bazooka' to restore confidence and halt the sell-off of government bonds issued by Italy and Spain. Many wanted the ECB to do this by buying large amounts of government bonds, an action that would have the effect of setting a ceiling on sovereign borrowing costs. The ECB had introduced a buying programme for Greece, Ireland and Portugal, and later extended it to Italian and Spanish bonds. But the amounts it purchased were limited, because the bank - established on the model of the German Bundesbank - did not believe it should interfere in fiscal policy. German members of its board strongly objected to bond purchases: its chief economist, Jürgen Stark, resigned and later wrote that governors had 'stretched the mandate of the ECB to extremes' and that it was 'an illusion to believe that monetary policy can solve major structural and fiscal problems in the eurozone'. It was not only German reservations that were holding the ECB back. Its president, Jean-Claude Trichet, and his successor Mario Draghi, who took over in November, also believed that the prime responsibility fell on governments to deal with the eurozone's problems, and that palliative action by the central bank would lessen the pressure on governments to make unpalatable decisions to deal with economic and financing difficulties.
Draghi's decision to launch the LTRO came only after Silvio Berlusconi had been ousted as Italian prime minister and as eurozone governments moved towards agreement on a fiscal compact that was intended to tie economic policies much more closely together. Having seen them make progress, the ECB had more confidence that, in taking direct action to provide the desired 'wall of money', it would not be throwing the money away or letting 'euro area leaders off the hook'. And by supporting banks, rather than governments, it was staying within its remit as a central bank and removing the immediate threat of systemic failure.
Buying time
The crisis is not over. There could be further serious disruption if Greece fails to meet the economic and fiscal conditions attached to a second international rescue package - though its debts have by now been largely written off or sold on. While Ireland has made great progress in turning its economy round, it remains vulnerable, as does Portugal. The new governments in Italy and Spain face big challenges in introducing new austerity programmes.
