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Calm Seas in Europe in 2014?



Compared to most predictions, not much happened in Europe in 2013. Yes, the Cyprus rescue and the restructuring of its banks were mishandled initially by European policymakers, producing the first capital controls implemented in the euro area. But there were no bank runs, and no euro area member collapsed into anti-establishment extremism. Indeed economic growth gradually returned in the second half of 2013, and unemployment rates stabilized. The euro area thus appears more shock resilient than during the volatile days of 2010–12, when the dreaded "contagion" spread from Greece to the entire region.

This is not a big surprise. It roughly corresponds with my forecast from a year ago. But will this relative tranquility last? My prediction is that it will in 2014, though as we saw at the last European Union Council meeting in late December, the risks of complacency have not disappeared.

No Electoral Upheavals Are in the Offing

No major EU elections are scheduled in 2014. In Italy, a new electoral law is unlikely to be agreed upon before it takes over the rotating EU presidency in the second half of 2014. By tradition, countries in that position refrain from holding national elections. Rather, European Parliament elections in May will be the political highlight of 2014. As discussed earlier, there is a risk that angry voters will turn out and elect some colorful non-mainstream members to that body. Still, there seems little risk that the European Parliament will become a "Weimar Parliament" with a majority of anti-EU members. Instead the established European parties seem likely to prevail with a smaller majority, ensuring that Europe remains governable.

With their increased representation, the question of what the anti-EU parties want (aside from their daily parliamentary allowances) will arise. Much has been written about the alliance between Marine Le Pen, leader of the French National Front, and the leader of the Dutch Freedom Party Geert Wilders. But theirs is little more than a photo-op coalition, posing limited political risks. There are inherent limitations on the ability of nationalist parties to collaborate across borders.

The European Parliament elections, though, may also indirectly influence the choice of the next president of the European Commission. In an attempt to broaden the democratic appeal of the European Union, the European political parties have suggested that they each propose a pan-European spitzen-kandidat for the post and then let the European voters decide. Of course, this is a naked—if well-intended—power grab by the European Parliament, as the right to select the Commission president resides with the EU member states according to the EU Treaty. And they are unlikely to surrender this right. At the same time, it will be very difficult for the EU member states to ignore the winning side in the European Parliament election. The heads of states will hence likely be compelled to at least choose a new European President from the side of the political aisle that won the most votes in the election. Their selection power will thus be constrained.

Another looming election is the referendum on Scottish independence due in September 2014, but the voting is certain to support the status quo. Scottish nationalists have been unable to credibly describe what an independent Scotland would look like, making it likely that most voters will avoid the risk of change. Rejection of Scottish independence is likely to affect Catalonia, where the regional government has announced it is holding a referendum on independence in November 2014. But the Spanish government has vowed to block the referendum as unconstitutional, and it seems unlikely to take place. As with Scotland, no one knows what an independent Catalonia would look like.

Catalan independence is a move that will be politically and administratively opposed by the rest of the euro area. An independent Catalonia should not expect to be grandfathered into the euro, or to host financial institutions that have access to European Central Bank (ECB) liquidity. The reason is straightforward, as the euro area takes over more functions of the member states (hence facilitating the breakup of countries), but on the other hand is still made up of member states. They will not want to send the signal to anyone in their own countries that breaking off is an easy thing to do, or that it automatically yields the benefits of EU and euro membership afterwards.

Look for the Stress Tests to Inflict Stress

Economically, the biggest event in 2014 will be the rollout of the ECB's asset quality review (AQR) and stress tests of the euro area banking system, representing the opportunity to finally restore the soundness of Europe's bank balance sheet. Failure to carry out a convincing review will threaten the region with Japanese-style prolonged stagnation and undermine the credibility of the ECB. The AQR/stress test is more important than the hotly debated single resolution mechanism (SRM) designed to close down or consolidate failing banks, finally agreed by the EU finance ministers in late December . Only a successful AQR/stress test can avert the continuing fragmentation of credit markets and reduce the high interest spreads between the core and periphery. Assuming that the SRM can fix financial fragmentation is erroneous, and much of the related criticism of the complex SRM compromise is misplaced. Even an optimally designed SRM would not make euro area banks suddenly lend to each other again.

A more pertinent question is whether the SRM compromise makes it more or less likely that the AQR succeeds in 2014. For sure the envisioned SRM is far from perfect. It has an excessively complex structure, including a 10-year phase-in, and a multistage resolution process involving a resolution board, the European Commission, and the EU finance ministers in the ECOFIN (finance ministers') Council. Parts of it are grounded in EU law and parts are to be embodied by a new intergovernmental treaty. Hopefully some of these kinks will be corrected in the ongoing final reconciliation negotiations on the SRM between the member states and the European Parliament. But writing off the SRM as unworkable just because it is complex is a mistake. The European Union of 28 member states works every day, despite breathtaking complexity. Moreover, in emergencies the European bureaucracy can be circumvented and a decision forced through in 24 hours.

In the end, the European Union has ended up with a sensible two-part framework, in which the bank regulator (e.g. the ECB) first determines whether a bank is solvent. Then, upon the ECB's recommendation—if the bank is directly regulated by the ECB or a cross-border bank in Europe—the SRM decides what to do with the dud bank in question. Somewhat ironically, a complex and untested SRM seems likely to act as a pre-emptive factor. The ECB would not want to declare a bank insolvent, if it had any doubts about the capacity of the SRM to act expeditiously. By agreeing on such a complex SRM, EU finance ministers may have helped ensure that the ECB will be extra vigilant during the AQR/stress tests exercise to minimize future banking problems.

On the issue of how to finance the new euro area resolution fund, the German support for absolute member state budgetary sovereignty prevailed. In the interim, the resolution fund is back-stopped first by national governments for their own share and the ESM as a last resort. Only by 2025, when the resolution fund is wholly paid up by industry contributions and taxpayer funds are no longer involved, will the funds' national compartments be merged into a genuinely single fund.

Financial crises and bank failures happen regularly. Sound and rigorous regulation prolong the intervals between such events. The ECB now has an additional strong incentive to ensure that large banks will not get into trouble for the first time in a decade, and only after the resolution fund is financed without taxpayer involvement.

No Major Political Initiatives Are on the Horizon

The EU Council, which met on December 19–20 , was largely dedicated to foreign and security policy, a luxury that only a region no longer in acute economic crisis can afford. The Council made it clear that the period of extraordinary crisis politics is finished in political (though not economic and social) terms. Germany is no longer under pressure to provide more financing than it wants—and therefore can no longer make big demands on other euro area countries in return.

In late 2013, for example, Germany dug in its heels on the financing of the single resolution fund, rejecting the appeal to sever the doom loop between governments and banks more thoroughly and quickly. But in an almost quid pro quo manner Chancellor Angela Merkel did not succeed in signing up other euro area members to her idea of "competitiveness contracts," committing themselves to undertake specific structural reforms in return for financial reward. Further decisions on the issue were merely postponed until October 2014. Absent crisis, Germany will therefore not be able to dictate the EU political agenda to the extent it has in recent years, and Berlin's political hegemony in Europe will be less complete in 2014. Regretfully, no other EU member has the political strength to put new things on the EU agenda. It is no coincidence that all the EU Council could agree on in December was to keep talking about Merkel's proposal. Don't therefore expect any major new political and institutional initiatives to be launched in the European Union in 2014.

This may not be a terrible outcome. In 2014, the European Union doesn't need a new vision. It needs to finish its existing agenda.

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