May 3, 2013 | 06:05 GMT

4 mins read

Perception and Reality in the EU Crisis

It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

There is a growing disconnect between Europe's economic realities and the perceptions of financial markets. Italy and Spain are dealing with deep recessions and rising levels of unemployment, yet they are successfully issuing sovereign debt at affordable interest rates. France last year lost its triple-A rating, and its economic condition continues to steadily deteriorate — but on Thursday, the country sold 10-year bonds at record low yields.

This is a striking change from just a year ago, when there was prevalent fear in the markets of imminent default by countries in the eurozone's periphery. Up until mid-2012, there was a strong link between perceptions in the financial markets and the actual conditions of economies and political situations in eurozone countries. In recent weeks, despite the traumatic bailout for Cyprus, the pervasive political crisis in Italy and the deepening unemployment crisis in Spain, some of the most troubled countries in the eurozone have been borrowing at relatively low costs.

What is a Geopolitical Diary? George Friedman explains.

The disconnect can be largely attributed to the promise of intervention in bond markets made by European Central Bank head Mario Draghi in September 2012. But even if this mitigates the potential for financial contagion in the currency union in the near term, it does little to address the region's much deeper problems: growing unemployment and dropping consumption.

European leaders have focused their efforts on solving the sovereign debt crisis and the resulting threat to Europe's banks. The main rationale was that government spending had to be dramatically curtailed to avoid defaulting on sovereign debt. But these policies have led to a massive social crisis in the eurozone periphery. Most countries in the eurozone are trapped in a vicious cycle where governments don't spend, banks don't lend and consumers don't consume.

Over the past three years, the European Central Bank has pumped 1 trillion euros ($1.3 trillion) of cheap loans into the eurozone's financial system in an effort to strengthen the region's banking sector. But banks are afraid they will not have their loans repaid and are therefore tightening credit. Additionally, recent EU regulations are forcing banks to reserve more capital.

Since most European companies depend primarily on bank lending for their funding, the credit crunch is undermining the eurozone's prospects for real economic recovery. This problem has particularly onerous effects on Europe's small- and medium-sized enterprises, which form the backbone of eurozone economies and represent the main source of employment. Despite the European Central Bank's injection of liquidity, these companies are still struggling to obtain credit. Statistics also highlight dropping levels of household consumption and savings in the eurozone periphery.

Moreover, social discontent with mainstream political parties is strengthening anti-establishment, Euroskeptical parties across the eurozone. While the European Central Bank has some power to appease financial markets, it cannot control the political evolution of individual states, much less quell discontent on the streets.

Some eurozone countries are trying to use the relief in the markets to negotiate softer austerity programs in an effort to reduce social unrest and undermine the popularity of the anti-establishment parties. The EU Commission recently allowed Spain and France to have softer deficit targets and suggested reaching a similar arrangement with Italy, highlighting the European Union's perennial dilemma between the demand for structural reforms and the tolerance for looser fiscal policies. While Brussels has made similar concessions in the past, this year the negotiation process was shorter and less traumatic than before. Brussels is aware of the political risks that austerity policies impose, and a more accommodating EU Commission is to be expected in the coming months.

Still, it will be extremely difficult for most eurozone member countries to return their unemployment rates to pre-crisis levels. Diminishing economic activity, poor consumption and a tight credit environment are severely limiting the periphery's chances for a substantial reduction in unemployment or a boost in consumption in the short term. The financial markets and the real economy move at very different speeds, with changes in the perception of the financial markets only marginally transpiring to a change in reality on the ground. Despite how the markets behave, social unrest and political uncertainty will continue to define the eurozone for the foreseeable future.

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