Hugo Dixon

Investors are feeling more optimistic about the euro crisis. So are policymakers. That much was evident last week at the World Economic Forum’s annual meeting in Davos. There was much satisfaction over the early performance of the Super Mario Brothers – Mario Draghi, president of the European Central bank, and Mario Monti, Italy’s prime minister. What’s more, a deal may be in the works to build a bigger firewall against contagion, constructed out of commitments from euro zone members and the International Monetary Fund. And it looks like there will be another short-term fix for Greece.

But three bad fairies were lurking at the Davos feast. Spain and France are relatively new problems and Greece is an old one. All three are powerful menaces.

Madrid is staring at a particularly vicious version of the austerity spiral afflicting most of the euro zone. The last government missed its fiscal targets, leaving the country with a budget deficit of 8 percent of GDP in 2011. The programme agreed with the European Union commits Spain to cutting this to 4.4 percent in 2012. Doing so would be hard in good times. Trying to reach this target when GDP is set to shrink by at least 1.5 percent and the unemployment rate is already 23 percent would be nearly suicidal.

Mariano Rajoy’s new conservative government is making a lot of the right noises. It is steeling itself for a long overdue overhaul of the labour market. It is also preparing to clean up its banks’ toxic balance sheets. But requiring it simultaneously to throttle the economy with such a severe squeeze would set it up to fail.

There’s an obvious trade-off: in return for going full steam ahead with the structural reforms, Madrid could be allowed a little longer to get its deficit under control. Such a deal could be applied to other countries too. But it would require Germany’s blessing – and that doesn’t yet appear to be forthcoming.

Now look at France. The majority of voters there have not grasped the need to reshape the welfare state to make it affordable. Nicolas Sarkozy spoke of reform at the beginning of his five-year presidential term, but did little more than push up the state pension age from 60 to 62 – which is still inadequate – and even that provoked howls of protest.

In his re-election campaign, Sarkozy is belatedly promising more changes, such as a shift in taxes from labour to consumption. While these could boost competitiveness, the incumbent is lagging in the polls for the April ballot. His leading rival, the socialist Francois Hollande, has suggested weakening the few reforms Sarkozy managed to enact. A rise in bond yields may be needed to shock the French out of their reverie.

Finally, don’t forget Greece. Even before the deal to restructure its debts has been inked, attention has turned back to Athens’ record as a serial breaker of promises. Given that up to 90 billion euros is supposed to be handed over to Greece in the next bumper bailout payment, it’s hardly surprising that some politicians in Germany are ratcheting up the pressure to make the country keep its side of the bargain.

The latest proposal doing the rounds in Berlin is for a virtual economic protectorate over Greece, an EU budget commissioner who could overrule the decisions of the Greek government and parliament on taxes and spending. This reduction of sovereignty has already provoked an angry response from the Greeks. But something clearly needs to be done to get the country on track. If the politicians in Athens are unwilling to accept help from abroad in running the machinery of government, Greece really will find itself squeezed out of the euro.

A compromise may resolve the latest Greek standoff, just as ways may be found for Spain to avoid an austerity spiral and for the French to recognise the need for reform. But solving the euro crisis is like running a marathon with hurdles. Each hurdle may in itself be possible to jump, but the race isn’t over and the runners are getting tired.

The euro zone shouldn’t rely on a bailout from the rest of the world. The International Monetary Fund is asking for an additional $600 billion to help deal with the euro crisis. But the euro zone, which is vastly richer than most of the rest of the world, should find the money to solve its own problems. It will be bystanders in the developing world that may need help if the euro blows up.

One can see why the IMF wants more money. An additional $600 billion on top of its existing firepower of $390 billion would take it up to a nice round number of $1 trillion. Not only would that give its bosses more swagger as they crisscross the world fighting fires but it would allow the IMF to play a big role in any bailout of a large euro zone country such as Italy.

But why should the rest of the world bail out the euro? The rich normally help the poor. But GDP per capita in the euro zone was $33,819 in 2011, more than five times that in the developing world, according to the IMF. As things stand, 57 percent of the IMF’s existing loans are to the euro zone, according to the Center for Economic and Policy Research. It’s not surprising that other countries are hardly rushing to funnel yet more money its way.

Developing countries need to look after themselves. As the World Bank’s report on Global Economic Prospects highlighted last week, the developing world is already suffering from the euro crisis – mainly because capital flows shrank by 45 percent in the second half of last year compared with the previous year. If the euro blows up, developing country GDP would be knocked by 4.2 percent, it predicts. Some 30 countries, which have external funding needs of more than 10 percent of their income, would be especially vulnerable.

The caution over providing more cash to the IMF is not due only to the fact that relatively poor countries are being asked to help rich ones. The United States and Britain are also reluctant to contribute. This is partly for political reasons: It’s impossible to persuade Congress to cough up money for the IMF in an election year when the U.S. deficit is nearly 10 percent of GDP; and it’s not that easy to get the British parliament, with its large contingent of euroskeptic MPs, to do so either.

There’s also a genuine belief that the euro zone is only in such a twist because of its decision to prevent the European Central Bank from buying national government debt in big quantities. The Federal Reserve and the Bank of England have, after all, bought the equivalent of 15 percent and 18 percent of GDP, respectively, of their own government bonds in an attempt to ward off recession. If the euro zone thinks such money printing will debauch its currency, so be it. But such a holier-than-thou attitude hardly gains sympathy elsewhere.

What’s more, there are alternatives. If Italy needs a rescue, why doesn’t the euro zone double the size of the European Stability Mechanism, its own planned bailout fund, to 1 trillion euros? The answer, of course, is that governments of countries such as Germany would find it hard to persuade their electorates to pour yet more money into southern Europe. But that attitude doesn’t get much sympathy either. Ironically, Germany is on the receiving end of the lectures it is so fond of dishing out to others – just as it tells southern Europe to get its act together, some in the rest of the world are telling the euro zone to solve its own problems.

To be fair, the euro zone hasn’t been sitting on its hands in recent weeks. Italy, for example, has made a promising start under its new prime minister, Mario Monti. And the ECB has been willing to provide unlimited funds to banks – an operation that may indirectly prop up the governments and even weaken, if not debauch, its currency.

To be fair, too, the IMF isn’t asking for cash just to channel from the rest of the world to the euro zone. Not only has the euro zone itself promised $200 billion but also the IMF’s resources could be used to help others caught in the backwash of any euro blowup. What’s more, an expanded war chest might restore investor confidence so much that the crisis recedes, to the benefit of everybody. Finally, the IMF would like the euro zone to beef up its own bailout fund simultaneously.

These arguments are fine as far as they go. But they can be applied with even greater force to the idea of just expanding the euro zone bailout fund. The IMF’s existing resources are perfectly adequate to bail out a raft of even fairly large emerging markets such as Turkey and Egypt. Moreover, if the rest of the world does give the IMF a bazooka, the euro zone will have less incentive to come up with its own. So it makes sense for the rest of the world to keep Europe’s feet to the fire, even if it ultimately helps out a bit. Germany’s Angela Merkel surely understands that logic.

Watch Athens more than Standard & Poor’s. The biggest source of immediate trouble for the euro zone could be the one country the ratings agency didn’t examine in a review that led to the downgrade of France and eight other states. Even if the short-term shoals can be navigated, the rest of the zone won’t find it easy to get by Greece.

The points S&P made when stripping France and Austria of their triple-A ratings and knocking two notches off the ratings of the likes of Italy and Spain were valid. It is true, for example, that policymakers can’t agree what to do to solve the euro crisis and that “fiscal austerity alone risks becoming self-defeating.” But these points, as well as the prospect of S&P downgrades, were already in the market.

Meanwhile, what Mario Draghi said last week about “tentative signs of stabilization” is true. The European Central Bank (ECB), over which Draghi presides, is itself partly responsible for that stabilization by virtue of providing 489 billion euros of three-year money to banks just before Christmas. Mario Monti’s promising beginning as Italy’s prime minister is the other main factor. The Super Mario Brothers have got off to a good start.

In Greece, though, matters go from bad to worse. The economy, which shrank about 6 percent last year, is now forecast to shrink an additional 4 percent or so by Credit Suisse and Goldman Sachs –- even worse than the International Monetary Fund forecast in November. What this means is that the numbers behind the latest bailout plan-cum-debt restructuring are probably out of date.

The immediate problem is corralling private-sector bondholders to swap 206 billion euros of bonds for new paper nominally worth half that value. There are actually two problems: persuading the negotiators for the bondholders to accept a deal and then getting virtually all the bondholders themselves to agree.

Despite the brinkmanship, which led the negotiators to leave the talks on Friday, it is likely there will be a solution — albeit a messy one. If the negotiators eventually agree, recalcitrant bondholders can be roped in by retroactively inserting collective action clauses in their contracts. If the negotiators don’t agree, there can be a formal default with losses imposed on everybody by diktat.

The snag is that restructuring the private-sector debt wouldn’t remotely close the Greek dossier as far as the rest of the euro zone is concerned. The question would then be whether to provide Athens with a bumper 90 billion euro tranche of bailout cash in March. The previous tranches have been much smaller: December’s, for example, was only 8 billion euros. But the debt restructuring means the next tranche has to be supersized: Up to 40 billion euros is required to recapitalize the country’s banks, whose balance sheets will be shot to bits because they are up to their gills in their own government’s bonds; a further 30 billion euros is needed as a sweetener to persuade the private bondholders to agree to the restructuring.

Politicians elsewhere will not find it easy to write the Greeks such a mega-check. There was much wrangling even before the previous smaller tranches, given that Athens’ finances were always worse than expected and that the country was never delivering on its promises. This time not only is serious money at stake but there will soon be an election that could bring in Antonis Samaras, the mercurial leader of the country’s conservative New Democracy party, as prime minister. He has been reluctant to embrace the austerity-cum-reform program that the euro zone and IMF want the country to follow.

Lending Greece such a huge sum when it’s not on track and is about to have an election would be risky. But the alternative would be for the whole program to fall to pieces. And despite the recent signs of stabilization that Draghi spoke of, other euro zone countries aren’t yet ready for an uncontrolled Greek default. So the best bet is that they will hold their noses, fudge things and hand over the money.

But that wouldn’t be the end of the trouble either. The continual bailouts mean that the public sector will soon have about 300 billion euros at stake in Greece. This is made up of loans by euro zone countries, loans from the IMF, purchases of Greek bonds by the ECB, loans by the ECB to Greek banks and permission given by the ECB to the Greek central bank to lend yet more money to its own banks.

The rest of the euro zone hasn’t been willing to see Greece default on its debts or leave the single currency because it has been worried about contagion. In future, the risk of contagion may be reduced. After all, if the current debt restructuring is successfully concluded, there will be less private-sector exposure to Greece, and so any second debt restructuring might cause less of an earthquake.

But even if the risk of contagion is smaller, the euro zone wouldn’t be able to wave good-bye to Greece. After all, the flip side of less private-sector exposure will be that vast 300 billion-euro public-sector exposure. Politicians -– such as Germany’s Angela Merkel, who faces an election in autumn 2013 –- won’t want to explain massive losses to their electorates.

In Greek mythology, Sisyphus was condemned to roll a boulder to the top of the hill, only to see it roll all the way down again. It looks as if the euro zone will be carrying its Sisyphean burden for a long time.

Semantics could help save the euro zone. There is a crying need to distinguish between fiscal austerity and structural reform.  The endless austerity programs adopted by the GIIPS — Greece, Ireland, Italy, Portugal and Spain — threaten to crush their economies so much that they are socially unbearable. By contrast, reforming pensions, labor markets and the like would be good for long-term growth. A policy mix that emphasizes the latter and draws some sort of line under the former is needed to stop the euro crisis spinning out of control.

Europeans have become grimly familiar with austerity spirals over the past two years. A government that needs to cut its fiscal deficit embarks on a program of tax hikes and spending cuts. The snag is that this fiscal squeeze, in turn, squeezes the economy — partly via the direct impact of cash being sucked out of the private sector and partly because the private sector loses confidence. The depressed economy means the government’s tax take doesn’t rise nearly as much as envisaged. So the deficit doesn’t decline much and, as a percentage of shrunken GDP, it falls even less. The governments’ creditors, led by Germany, then demand another round of austerity to get the program back on track. With each round, the howls of pain from the population increase, belief that there is light at the end of the tunnel declines and the government’s political capital shrinks.

The Greeks, Irish and Portuguese have been trying to run up this down escalator the longest. Italy and Spain are now embarking on the same regime. Yet more doses will be required over the coming year if the policy mix is unchanged. After all, last year’s budget deficits are expected to be about 10 percent for Greece and Ireland, 7-8 percent for Spain and Portugal (if a one-off pension transfer is ignored) and 4 percent for Italy.

Some austerity was needed given that expenditure had run out of control in the boom times and that, in some cases, there was a deliberate fiscal boost in the aftermath of Lehman Brothers’ bankruptcy in 2008. In Greece’s case, there was also a failure to implement the programs properly, meaning time and credibility were lost. But endless rounds of austerity are debilitating. The better approach would be to have one chunky program that is properly implemented and then rebuild.

Of course, the creditors aren’t willing to give something for nothing. But this is where a semantic distinction between austerity and structural reform could be helpful. Both require political courage by a government and sacrifices by its people. But the former pushes an economy down, while the latter boosts it — albeit in the long term. A virtuous cycle is even possible with the economy reviving, tax income rising, the deficit falling and confidence returning.

Pushing up retirement ages is a case in point. This doesn’t just reduce government spending, especially in the long run as savings build up year after year;  it also increases the productive potential of an economy by expanding its work force. Or take labor reform. Making it easier to hire and fire people puts downward pressure on wages, improving an economy’s competitiveness and reducing unemployment — which, in turn, cuts government spending on social security.

Other desperately needed reforms — privatization, liberalization of product markets, and increasing the efficiency of the public sector and the judiciary — would also improve long-term growth. Privatization would have the added benefit of cutting government debts, as would crackdowns on tax evasion.

The GIIPS have all done something in the field of structural reform. Italy, Spain and Greece, for example, are pushing up retirement ages. But the reforms have been slow in coming and sometimes half-hearted. Greece is the worst example: little has happened on tax evasion or privatization. Meanwhile, the new governments in Rome and Madrid have yet to get to grips with labor reform, although they are indicating that they will do so soon.

If the GIIPS could convince their creditors that they were serious about such reforms, they would win brownie points. That would put them in a better position to avoid yet more rounds of austerity. After all, Germany’s Angela Merkel would still be able to argue to her people that the peripheral economies were serious about change. What’s more, the economies of Germany and other creditor nations would benefit. Austerity in their neighborhood combined with the threat that the whole euro zone could blow up is not good for business. But to start the process, policymakers and pundits need to stop talking about austerity and reform as if they are the same.

PHOTO: A one euro coin is held in an adjustable spanner in this picture illustration taken in Ljubljana, January 4, 2012. REUTERS/Srdjan Zivulovic