“The most divisive development in post-war Europe…imposing enormous costs on citizens” in the form of stagnation and unemployment. “The [euro] crisis will drag on…It cannot be resolved without confronting either the supranational ambitions of the EU or the democratic nature of sovereign national governments. One or other will have to give” – Mervyn King
Those of you who are unfamiliar with the topic should watch this excellent 12 minute video on The European Debt Crisis.
Source of featured image: http://www.zerohedge.com/news/2016-09-02/italian-referendum-could-result-death-euro
Joseph Stiglitz, American economist and winner of the Nobel Prize in Economics, has come out with a new book, “The Euro: How a Common Currency Threatens the Future of Europe”. His skepticism (which you can listen to here) is shared by a growing number of economists such as Mervyn King. The basic problem is that a monetary union (shared currency) without a fiscal union is unsustainable.
Imagine sharing a credit card with your whole extended family. What would happen? You have a good job and credit history (i.e. Germany) so having your name on the card will keep the interest rate low. Others more inclined to spend beyond their means (i.e. Italy) will likely take advantage of the low interest rate. What about the bank extending credit to your family (i.e. investors)? The bank is fine so long as your name is on the card. However, for the past several years, Uncle Joe and Aunt Susie have continually bought things they couldn’t afford. At first they were apologetic, but now they just spend with the expectation of you paying it off. What do you do?
At no point in the decades leading up to the creation of the EU in 1999 was Italy able to borrow at the same interest rate as Germany. Then, for nearly a decade, Italy was allowed to borrow at essentially the same low rate as Germany. Once the Financial Crisis hit investors woke up to the possibility that the Italian government could default on their debts. Rates diverged and peaked during the Sovereign Debt Crisis. Since then rates for German and Italian have been driven down in large part because of ECB Quantitative Easing. [Source of Chart]
The run up in debt by European countries like Greece, Spain, and Italy was a natural consequence of letting them borrow Germany’s credit card via the Euro.
A shared currency (i.e. monetary union) without a fiscal union is unsustainable. The geographical area that shares the common currency must also agree to share labor, capital, and the pain of an economic shock. The Eurozone has greatly reduced barriers to free flow of labor and capital, but the pain of economic shocks is a burden mostly carried by southern Euro countries. For this reason, it seems likely that voters in these countries will grow weary of the Euro and eventually force the short term pain of exit for the long term gain of a sovereign currency.
A sovereign currency acts as a shock absorber. Imagine driving down the road and hitting a pothole. You feel it, but there is no major damage to the car because the shock is mostly blunted by your suspension. The suspension reacts only to your car. The degree to which it contracts is proportional to the size of the shock. Now imagine a new “high tech” suspension that, for reasons that defy logic, contracts in proportion to the shock of 20 cars driving down the road together. Perhaps only 5 cars will hit the pothole and so the suspension only contracts at 25% (5/20) of the proportion that it would otherwise. Those who hit the pothole would nearly bounce out of their seats while those that did not would get that queasy feeling one experiences on a Ferris wheel just as it turns down.
The Financial Crisis did not hit all countries with the same “shock”. Southern European countries like Italy suffered the worst and have continued to suffer to this day. Northern countries such as Germany experienced a minor shock and were back to growth within a year! Why…because the Euro (suspension) contracted in response to the Financial Crisis (pothole) in proportion to the average impact on all countries sharing the Euro. This has left countries like Italy with a flat tire (high unemployment) and Germany with a low-rider (low Euro means cheaper exports).
The value of the Euro is determined, like all financial assets, by supply and demand. The Euro dropped sharply during the Financial Crisis as demand for the Euro dropped as measured by capital moving to safer investments in the USA and Japan. However, within a year northern European economies were recovering and so capital started moving back. Increased demand drove up the Euro for ALL Euro countries regardless of whether they had recovered increasing the cost of ALL Euro denominated exports. Germany handled this fine because they had already started to recover, but southern Euro countries like Italy have suffered. The shared “suspension” gave more slack to Germany than it needed, and not enough for Italy. Without a sovereign currency to take the brunt of the shock, Italy has had to endure a prolonged period of stagnant wages and an unemployment rate over 11% since 2012. [Source of Chart]
If Italy had had a sovereign currency like the United Kingdom then it seems likely that things could have been different. After Brexit the pound dropped 12% within two days. This provided the United Kingdom with a power shock absorber essentially putting their goods and services up for sale immediately after investors started to question the strength of the UK economy. Will the UK economy suffer from Brexit? Perhaps, but there is no question that having a sovereign currency helped soften the blow.
More integration is needed to save the Euro
Ironically, the father of the Euro, Robert Mundell, laid out the conditions required for a single currency to prosper:
- Free flow of labor and capital
- Shared burden of shocks (including Significant fiscal transfers )
The United States meets these conditions. Citizens are able to freely move across borders between states. Welfare programs, a progressive tax system, national funding for disaster recovery (FEMA) & education, all provide mechanisms by which the burden of shocks to one part of the country are shared by the whole.
The European Union only partially satisfies these conditions. Differences in language, culture, and national identities are all headwind to labor mobility. The Financial and Sovereign Debt Crises had an uneven effect on Euro countries with those in the south suffering more than those in the north. These burdens have tested the willingness of wealthier northern EU countries like Germany to help southern EU countries like Italy via debt forgiveness and other forms of fiscal transfers.
The Euro can only work if Euro countries become more integrated (see below). Going back to the family credit card example … you would only give your extend family access to your credit card (monetary union) if they agreed to certain rules and restrictions. They would need to get a job and agree not to spend more than they can afford (fiscal union). In other words, EU countries need to be willing to give up more of their sovereignty.
Public opinion is shifting away from integration
Integration is the only way to save the Euro, but popular sentiment is moving in the opposite direction. About half of Europeans have maintained a favorable view of the EU since 2012, but the portion that believe more power should be transferred to national governments has grown to 42% compared to just 19% that favor more centralized power. This shift in sentiment has created a growing number of “Independence” political parties across Europe (such as the Freedom Party in the Netherlands and Front National (FN) in France) with the central aim of bringing more power back to national governments.
Why the shift in public opinion? Part of it is certainly due to the chronically high unemployment of countries like Italy and Spain. However, there are much broader trends at work as well. As mentioned in my previous observation on the Fourth Turning, faith in our institutions and Democracy itself appears to be fading. Populist movements are fueled by distrust in our “institutions” and a willingness to roll the dice on something new. In this case, the “institution” includes all the steps taken by the Eurozone countries since WWII to integrate…including the Euro.
These trends run contrary to the growing consensus among experts that steps toward a fiscal union (above) are necessary if the EU is to avoid a breakup as the status quo is unsustainable. However, a move toward further integration requires faith in the ability of democratically elected governments to help improve the lives of their citizens. Those who lack faith in government tend to prefer a more local government (i.e. not one in Brussels). The growing lack of faith is a key reason why the Economist Intelligence Unit has forecasted a 25-50% chance of at least one EU member leaving the Euro within the next two years (Nov2016 Report).
Since 2010 European politicians seem to only make real progress with their backs against the wall. Given that track record, it still seems unlikely that even the more extreme political parties will exit the Euro on a whim. The more likely scenario is that nothing meaningful will change until the next crisis. What crisis could unfold? That we can’t know. However, the political will to move forward toward a more sustainable fiscal union seems unlikely without another crisis.
The next year will be critical
Next year, 75% of the Euro area’s economy will be going to the polls. The Italian Referendum is just the beginning. Momentum in public opinion, on both sides of the Atlantic, is clearly on the side of more sovereignty (me first) and more border control (less labor and capital mobility). All it takes is one country seriously considering an exit from the Euro for markets to react. The anticipation of the leave would likely cause the Euro to fall further and send credit spreads higher. As mentioned in my previous observation on the “Only Game in Town, the ECB is mostly out of bullets to fight these consequences. Their QE program is already running out of bonds to buy. One reason Italian bonds are trading at yields not much higher than Germany is because of this QE program which is currently scheduled to taper in March 2017. Changing the rules might allow the program to continue through 2017, but this requires the consent of Germany (the only ultimately responsible for paying off the “credit card”).
The Euro appears unlikely to survive in its current form. The only two questions remaining are when the first country will exit, and what the resulting Euro zone will look like. There are many potentially good longer term outcomes. However, the near term consequences are almost certainly going to be painful. New currencies would have to be established. The relative value of these currencies would be unknown. Some would lose value very quickly while others would shoot up. Exports would become dramatically uncompetitive in some cases, and in others they would become so cheap that there may be accusations of dumping, currency manipulation, and calls for immediate reintroduction of import duties to level the playing field. Such duties, if imposed, would break up the single market. That would be tantamount to the break-up of the European Union itself. This is what happened when the ruble zone broke up in the 1990s and explains why incomes fell by 50% in the former ruble zone countries.
Joseph Stiglitz argues for a breakup of the Euro into two separate currencies would be a good solution. Stronger economies like Germany and France would take the existing Euro. Weaker economies like Italy and Spain would take on a new currency (ex. Euro-light). He argues that this would allow for many of the Euro zone benefits (less currency risk than when all countries had their own currency) with little cost. Mervyn King and George Soros are highly skeptical that the Euro can survive with Greece. Thus, another potential solution would be to shed the weakest economies like Greece (and perhaps Italy and Spain) altogether.
The trouble with these solutions is that the Eurozone does not currently have a mechanism for making these transitions. Thus, any near term (1-2 year) transition would likely be very disruptive.
Further reading: This is why Robert Shiller was wrong to expect “mean-reversion” of CAPE ratios between US and EU stocks as discussed in the observation “What is a Bubble”. This forecast also seems consistent with my observations on “How the Economic Machine Works”, and “The Fourth Turning”.
Feel free to share your own thoughts on the Euro. There is no better compliment you can give us than your thoughtful criticism. You can reach us at email@example.com, or follow us on Twitter @intuitecon
Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.