As European leaders stumble into a make or break year for the euro and perhaps the European Union itself, the ranks of the optimists are thinning markedly. But Jens Larsen, chief European economist with RBC Capital Markets in London and a former official with the Bank of England, remains one of them. Indeed, he remains convinced that the current crisis will eventually result in a stronger currency union and EU itself.
"People are only now coming to realize that you're not going have a sort of cataclysmic event, but equally, you're not going to have a very good event that suddenly resolves the crisis," Mr. Larsen told me on a recent visit to Toronto. "It's a very, very gradual process."
Here's an edited version of our conversation.
Brian Milner: You're missing the latest Merkel-Sarkozy summit.
Jens Larsen: The good thing about their summits is there will always be another one. Certainly, there seems to be no end to them. In the lead-up to these summits … was the expectation that they have to come up with a great thing, and you're going to have a solution to all the problems. And that's not going to happen.
BM: Are the markets now accepting this? Can they live with the euro zone just muddling through?
JL: I'm not sure they can live with it. But there's a growing realization that those summits are not going to resolve the issue. You're not going to have the ECB stepping up its [bond]purchases very suddenly. You're not going to have a euro bond being introduced overnight. You're not going to have a sudden agreement between all 17 countries on a fiscal framework.
BM: But you do believe they are moving toward some of these.
JL: You're seeing progress on the fiscal front, in the sense that they're closer to reaching an agreement. I'm not sure it's the right kind of agreement. But that's the natural precursor to the discussion about euro bonds. I don't think they're going to do that in February, or indeed any time soon. But the idea that we're moving towards … a fiscal union is a pretty firm direction. More people are coming to realize that that's the direction. That doesn't mean it's a very comfortable path, because there are lots of potential bumps on the way.
BM: What are those bumps in the road?
JL: The current Greek situation is one. If you had asked me before the ECB announced those three operations [measures to shore up the region's banks] I would have been worried that an intensification of the pressures on European banks could have been another. And in the course of the first quarter of this year, there will be very substantial debt issuance by Italy and Spain. Each of these auctions is a potential event risk. So there is still plenty of scope for things to go wrong. But I think that since the political direction is firm and established, agreements will be reached, first on a new treaty and I think eventually on euro bonds.
BM: That would require the Germans to drop their opposition to euro bonds, which they would largely have to guarantee.
JL: I think it is a consequence of coming to an agreement on the fiscal compact. I don't think the German government is going to be in a position where it will be easy to accept euro bonds. The Free Democrats, the junior coalition partner, will struggle coming to an agreement on that. So you might have to get to the point where you have a change in the government. The German elections are not until 2013, so that could be some way off. But certainly the dynamics of that discussion are changing. The Germans are getting what they have asked for, in terms of economic governance. So I think there will be movement there, eventually.
BM: The French have presidential elections in the spring. Do you see a potential for the French to end the cozy alliance with Berlin if the opposition Socialists, who are leading in the polls, win?
JL: I struggle to see that an incoming French government would take a substantially different fiscal position to the current one, in either direction. But six months down the line, you could see a French government – but also other governments – putting more pressure on the Germans to change the long-term economic strategy in Europe. They're having summits about growth now. At the moment, that seems mostly to be words. But the idea that you can achieve rebalancing in Europe only by focusing on fiscal austerity is a flawed one. And the rest of Europe is coming to understand it. The Germans are still some way away from appreciating that. This is not just a fiscal problem.
BM: You're talking about the yawning competitive gap between the poorer countries of southern Europe and the wealthier countries of the north. What's needed to close this?
JL: Economic reform, wage and price restraints are certainly part of it. But a rebalancing of demand is another way. You need stronger domestic demand in Germany for this to work.
BM: Do you see the Europeans being able to do all this within the single currency framework, even though they have made no progress over the past decade?
JL: I think so. Financial, monetary and economic integration has been an important driver of growth in Europe. Part of that, of course, has been those imbalances that now need to be corrected.
BM: You have seen the crisis as a driver for vital reforms that will make the European Union stronger. Do you still believe that?
JL: Yes. The trouble comes from having these tight links. But the answers to the problems don't come from pulling the links apart. Strong financial and economic links are important for underpinning growth. But what they have allowed to happen is for these fiscal and financial imbalances to build without addressing them.
BM: How does that play out?
JL: They need to rebalance in southern European countries. Economic reform is part of that; fiscal restraint is part of that. But the important thing is demand rebalancing in the surplus countries, in particular Germany. They've got a problem too. It's not just the deficit countries. It's a sort of small picture of the global imbalances issue that we face, with China, in particular, running large current account surpluses and the U.S. running large deficits. You need an orderly process for rebalancing. In Europe, you have a much stronger framework to deal with those imbalances. But at the moment, the strategy is one of letting everyone, in particular the deficit countries, tighten fiscal policy.
BM: But at the end of the day, if you have a bunch of weak countries in a currency that's too strong for their economies, you need some mechanism for transfer payments, don't you?
JL: Well, you need transfers to keep the show on the road. But you also need a competitive adjustment. The practical way to achieving a rebalancing in Europe is to have relatively subdued wage and price inflation in the periphery countries. But the opposite, to make that rebalancing path acceptable, is to have relatively strong wage and price inflation in the core countries. That's a way of re-adjusting the real exchange rate between the two when the nominal exchange rate is fixed. If, for some reason, you pursue policies that keep inflation low and stable and wage growth subdued in Germany, then you're going to basically require wage contraction and deflation in the periphery countries. That's nasty.
BM: Do you see the entire 17-country euro zone still intact by the end of 2012?
JL: Certainly at the end of 2012. I don't think it's in anyone's interest to break free or to kick anyone out. Greece is the most obvious candidate. If either they boot themselves out or they're booted out, it would be very difficult to keep the union together. So I don't think it's going to be attempted.
BM: What about longer-term?
JL: Are the peripheral countries going to be able to sustain these imbalances for that long? Are they going to be happy with weak growth for five years? Are they really going to pursue fiscal austerity for that long? Isn't there a point where the political establishment in Spain says unemployment cannot carry on rising? I think that's the kind of tension you will see. I don't think that leads necessarily to the dismantling of the euro area. But it will certainly mean that the push towards fiscal, financial and economic integration might be less. And you will find a continuous political struggle at the core of the euro area, which is not good for anyone.