Europe after the Fed stops printing

Since the start of the Federal Reserve's third round of quantitative easing in September 2012, global markets have been buoyed by an ample supply of liquidity. Experience with previous favorable global liquidity environments, however, should have taught us by now that those favorable environments do not last forever. We should also have learned from experience that when global liquidity is no longer ample, markets again become unforgiving of poor economic and political fundamentals.

In light of that experience, it has to be regretted that over the past two years European policymakers have not taken full advantage of the breathing space that more favorable global market conditions have afforded them to take those structural economic measures that might have placed the euro on a firmer footing. Instead, they have allowed themselves to be lulled into a false sense of security by the removal of market pressure. Sadly, this has to heighten the risk that the eurozone will experience yet another crisis once the Federal Reserve starts the process of normalizing interest rates.

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Over the past two years, the Fed's unprecedented expansion of its balance sheet to its present size of over $4.25 trillion has resulted in highly favorable global liquidity conditions. Those favorable conditions in turn have driven a powerful global market rally across all high-risk products and have returned European bond yields to pre-crisis levels. And they have done so despite an appreciable deterioration in the debt and political fundamentals of the European economic periphery.

Among the eurozone's most acute economic vulnerabilities is the very poor state of its periphery's public finances. According to Eurostat, by the end of the first quarter of 2014, the public debt to GDP ratio had reached as high as 174 percent in Greece and more than 130 percent in Ireland, Italy and Portugal. More troubling yet, those ratios showed little sign of stabilizing, with those ratios having risen over the past year by 15 percentage points in Greece and by 5 percentage points in both Italy and Portugal.

One would have thought that those ever-rising debt ratios would have shaken European policymakers out of their present state of complacency about the risks of a recurrence of the European sovereign debt crisis. This would particularly appear to be the case at a time when Europe's anemic economic recovery already appears to be running out of steam and when heightened geopolitical risks both in Ukraine and the Middle East could further undermine that recovery. It would also seem to be the case at a time when large product and labor market gaps are already driving Europe toward outright price and wage deflation.

In the context of little or no growth in nominal income, the countries in the European periphery will be required to generate much higher primary budget surpluses than they are now doing if they are ever to restore public debt sustainability. However, it would seem to be far from clear whether those countries will be politically able to make such a fiscal effort at a time when their politics are fragmenting and their economies are suffering from acute austerity fatigue. It would also seem questionable whether a new round of budget austerity within the straitjacket of the euro will do much to improve the European periphery's public finances, since it might only serve to drive those economies further into recession.

Considering Europe's shaky debt and political fundamentals, European policymakers' complacency would appear to rest on two questionable premises. The first is that global liquidity conditions will stay ample for a long period of time. The second is that should the going get rough for Europe, markets will continue to buy into the notion that the European Central Bank (ECB) will be there to backstop any member country under real financial market pressure.

Sadly, all the clues seem to be pointing in the direction that both of those premises will turn out to have been very faulty. After all, the Fed has already made clear that it intends to have exited quantitative easing by October 2014 and that it stands ready to start raising interest rates once U.S. unemployment has declined to the Fed's desired level. For its part, right from the very first announcement of the ECB's bond buying program, the ECB has made it clear that it will only buy bonds of those member countries that are prepared to submit themselves to economic adjustment programs. Considering the mounting domestic political backlash against budget austerity and structural economic reform across the European periphery, it is far from clear that the ECB will be in the positon to make such large-scale purchases.

With time running out, one has to hope that the ECB will move soon to aggressive quantitative easing in an effort to revitalize Europe's flagging economic recovery. One also has to hope that European policymakers will redouble their efforts toward banking union and that the eurozone's surplus countries will adopt an easier fiscal policy stance in an effort to provide much-needed support for the European economic periphery. For if European policymakers do not move quickly in that direction, we should start bracing ourselves for another, and possibly yet more virulent, round of the European sovereign debt crisis once the Federal Reserve starts to raise interest rates next year.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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