October 1, 2012
The crisis in the euro area is beginning to feel like a permanent piece of the world's economic landscape: a great red spot that just churns and churns and never goes away. It isn't, though. One day the crisis will be over, either because the euro zone managed to muddle through or because it didn't, and came apart.
To avoid coming apart, the euro zone needs to accomplish three things. First, it needs a policy mix from the European Central Bank and from its member states sufficient to prevent a market panic leading to a quick end. There have certainly been moments when it seemed as though it would fail this first task, but at every point enough action has been taken to prevent an immediate disaster. The ECB's role has steadily evolved and has in the process reduced the risk of an implosion of the banking system and contagion across sovereign debt markets. And at the same time, Europe's governments have—slowly, haltingly, inadequately—begun building an infrastructure for a banking and fiscal union. The odds of a Lehman like miscalculation precipitating a sudden financial catastrophe and break-up seem to have steadily receded.
Yet that is just the first hurdle. The euro area also needs to reestablish strong growth, sufficient to begin meeting fiscal goals. On this score, the euro area has done very poorly. The story is more or less this. The crisis, recession, and capital outflows of 2008-09 led to broad weakness in the domestic economies of many peripheral countries. On top of this troubled sovereigns have been raising taxes and cutting spending in order to try and meet budget goals (some necessitated by markets, some imposed by core economies in exchange for fiscal assistance). The result was a descent back into recession, which has in turn worsened budget balance, undermining the process of fiscal consolidation. This weakness could be offset by rising net exports, but the peripherals biggest trading partners are in the same boat, and the world's other large economies aren't doing that great either and are also trying to raise net exports.