Greece, Not Italy, Still Poses Biggest Challenge to Eurozone

A crisis in one country only becomes a crisis for the whole eurozone when a collective European response is required, Simon Nixon writes

The Wall Street Journal

By SIMON NIXON
Dec. 7, 2016 3:27 p.m. ET
4 COMMENTS
Not for the first time this year, the doom-mongers have been confounded. The Italian referendum over the weekend resulted in a resounding defeat for Prime Minister Matteo Renzi, who promptly announced his resignation. Yet the sky didn’t fall in, the euro dipped and then rallied, and Italian bonds and bank stocks barely budged. Other European assets were also largely unmoved.



Why didn’t markets react how some had feared—and those who dream of the failure of the European project had hoped? One answer is that Mr. Renzi’s defeat was in the price: Markets had anticipated it. Another explanation is that the referendum, like the Brexit vote and the election of Donald Trump, doesn’t in itself change anything. Political consequences can and will follow from the decision, but it is too early to say what these will be and the markets will wait to assess them.

But the main reason Europe isn’t now in turmoil is that Italy’s problems are likely—for now, at least—to stay in Italy. These problems are hardly new and reflect a long-running crisis of domestic governance.

They became apparent in the years after Italy joined the euro and was no longer able to rely on frequent devaluations to maintain its competitiveness with Germany. These devaluations masked serious problems with its economic model: In a new world where goods, services, capital and people could move freely across the European Union, Italy’s high taxes, excessive bureaucracy, inefficient justice system and inflexible labor and product markets had made it uncompetitive, resulting in low investment, falling productivity and weak to nonexistent growth.

Italy was hardly the only country whose economic model was exposed by the global financial crisis, but it has been among the slowest to deliver reforms. Countries such as Spain, Ireland and Cyprus, which have made the most far-reaching overhauls of their welfare states, banking systems and labor and product markets have staged the strongest recoveries. Mr. Renzi’s defeat may well be a setback for Italy’s future economic prospects, not least because his proposed constitutional changes were designed to remove some of the institutional and political obstacles to reform—though this remains to be seen.

But what has become clear over the past seven years is that a crisis in one eurozone country only becomes a crisis for the whole bloc when a collective European response is required. That is because the eurozone’s own governance doesn’t allow for effective political decision-making. The single currency endured several near-death experiences as it fumbled its way to a response to successive Greek crises until the creation of its own bailout funds brought some stability. But in the past few years, the eurozone’s serious governance deficiencies have been obscured by the European Central Bank’s quantitative-easing program, which has provided a support to government-bond markets, taking the pressure off governments to take hard decisions.

In fact, some policymakers fear that the eurozone’s capacity to take decisive political action is now weaker than ever. Already this year, the parliament of Wallonia in Belgium came close to derailing an EU free trade deal with Canada, while a referendum in the Netherlands blocked an economic and trade agreement with Ukraine.

Meanwhile, the growing strength of populist parties in national parliaments is reducing the political scope for action at both the national and EU level that might put the eurozone on a more stable footing. For years, the EU has comforted itself with the notion that it only ever moves forward in a crisis. But this isn’t just an unsatisfactory way to govern anything—it may no longer even be true.

Viewed this way, the most urgent test of the eurozone’s decision-taking capacity isn’t Italy but Greece. Italy will only become a eurozone problem if it is forced to ask the eurozone for aid, which seems unlikely while the ECB continues to buy its bonds. But the risk of a new Greek crisis is real unless the eurozone can find a way to break a longstanding impasse among Greece, Germany and the International Monetary Fund over the next phase of Greece’s bailout.


Germany has said it won’t disburse any more cash unless the IMF joins the program. The IMF won’t join the program until the eurozone agrees to put Greece’s debt on a sustainable footing, but the eurozone won’t know how much debt relief Greece needs until Athens and its creditors agree on what Greece’s long-term budget targets should be—and the policies to deliver them. If a deal isn’t struck quickly, before the eurozone enters an extended cycle of national elections, the next opportunity might not arise before the summer, by which point Greece is likely to once again face liquidity pressures, undermining the current bailout program.

Nobody wants another failed Greek program, not least when Greece’s geopolitical importance is growing. Yet some officials struggle to see how the situation can be resolved, perhaps not this side of the German election in September. And if the eurozone struggles to resolve its differences over Greece, what does that say about the bloc’s capacity if it becomes necessary to help Italy?