The Euro-zone appears to have been in a state of permanent crisis since the 2008 financial crash. The key issue is that continued inability to resolve economic vulnerabilities will continue to corrode political support.

Overall, it is increasingly unlikely that the current structure will be sustainable, especially when extraordinary ECB monetary support fades and unemployment starts rising again.  The UK decision to leave the EU will also cause major uncertainties.

A full-scale collapse of the Euro is certainly possible given the difficulties in holding together a currency union comprised of individual nations. The more likely outcome is that there will be major reform and, potentially, a narrower and deeper currency union.

Underlying vulnerabilities not resolved

The Greek debt crisis has still not been resolved close to seven years after first erupting, primarily because the underlying causes of the debt crisis have not been resolved.

The original bailout programme was primarily designed to protect European banks rather than support the Greek economy and there has been extremely strong resistance from Germany to alleviate the debt burden.

Greece is still being maintained on life support with debt repayments being met through fresh loans. Meanwhile, GDP is continuing to stagnate at best and there is always the risk that popular discontent will trigger Greek decision to leave the Euro despite a potentially very high cost.

ECB lifeline buys time

The ECB has pursued a very aggressive monetary policy with the deposit rate cut to -0.40% while there has been a quantitative easing programme including the sustained buying of government bonds which is set to run until the end of 2017.

The very supportive monetary policy has provided important support to the Euro-zone economy and growth conditions have improved notably over the past few months with further improvement likely over the next few months. Growth has, however, still been concentrated around Germany with vulnerabilities among weaker countries.

Economic divergence continues

Underlying economic divergence has continued to be a major problem for the Euro area with a crucial lack of growth within the weaker economies. Unemployment has remained at extremely high levels in countries such as Spain while underlying growth has been very weak in Italy.

Although the ECB policies have cushioned these economies, any turn in monetary policy and a gradual monetary tightening would substantially increase the risk of a fresh downturn in the weaker economies.  

Another economic downturn would put renewed upward pressure on unemployment and there would also be an increase in popular opposition to conventional economic policies.

Politics will be decisive

The underlying vulnerabilities in the Euro area will be seen through economic developments, especially if growth falters again and unemployment remains at extremely high levels.  Ultimately, the Euro-zone future will be decided by political developments with the economic pressures expressed through popular opinion and demands for reform.

The degree of Euro-zone support within the population will be extremely important as will be the response by national governments and wider EU institutions.  

Fiscal union still a key issue

A fundamental mechanism which exposes Euro-zone vulnerability is the lack of any fiscal union. Budget policies are still driven nationally and there is no remit for any re-distribution of funds from the stronger countries to the weaker ones.

This is in strong contrast to the situation in national economies where there is a net flow of funds to the weaker areas through fiscal transfers. Over the medium term, some form of compromise will be essential.

UK move complicates issues

The UK referendum decision to leave the EU has further added to Euro-zone complexities. If the UK appears to be on track for attractive exit terms, there will be an additional temptation for other countries to follow suit. Wider political uncertainty will also inevitably increase during negotiations.

There is also the potential for further pressure to boost competitiveness in the area of corporate tax cuts which would increase strains within the Euro area.  

Pivotal French Presidential election

German and French elections this year will be extremely important given their pivotal roles in the Euro area. The French Presidential Election is the next major test and will bring underlying structural issues into sharp focus.

The first round of the contest will be held on April 23rd with the second-round run-off on May 7th.

The principal focus will be on the performance of National Front leader Le Pen. If elected, she has pledged to revoke central bank independence, increase government spending and re-introduce the franc which would trade in parallel with the Euro.   

A Le Pen Presidency would be likely to face strong opposition from within parliament but there would be a major loss of international confidence surrounding the French and Euro-zone outlook.

Current opinion polls suggest that Le Pen would lose a theoretical second-round run-off against Macron or Fillon by around 60-40%. A National Front victory looks unlikely, but a strong showing would increase reform pressures.

Germany also faces Federal elections in September or October with a significant risk that Chancellor Merkel could be defeated. Merkel has been a key force of stability within the Euro area and her defeat would raise fresh doubts surrounding the Euro area.

There is, however, an alternative view that the removal of Merkel could allow a shift in policies which would strengthen the Euro area.

Italy is also likely to face a fresh general election this year.

Collapse or reform

On a medium-term perspective, the Euro-zone will continue to face major difficulties under the current structure. Any fresh global economic downturn and a move towards recession in the Euro area would be likely to push political sentiment to a point where the consensus for monetary union collapses.

There is the risk of a total failure of the Euro area with a slide back towards national currencies.

Overall, it looks more likely that there will be a major structural reform with the hard-currency countries surrounding Germany pushing to a deeper monetary union while weaker countries will adopt a weaker bloc.

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