George Magnus: the eurozone experiment is in danger of blowing up

Merryn Somerset Webb talks to economist and author George Magnus on national sovereignty, economic integration, and the eventual collapse of Europe's botched currency union.

If you missed any of Merryn's past interviews, you can see them all here.

NB: This interview was recorded before the deal of 12 July was agreed with Greece

Merryn: Hi, I'm Merryn Somerset Webb, editor-in-chief of MoneyWeek magazine. I'm here today with George Magnus who is senior economic adviser to UBS, and also an associate of the Oxford University China Centre.

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We've got a lot to talk about today George, there's an awful lot going on. The first thing I want to do is actually start with China. We've just seen this stunning crash in the stockmarket, and I'm wondering what you think has happened here, and what do you think is going to happen next? Big questions, but important ones.

George: Well, I think that the crash is obviously of now, what, 30%-40% magnitude? But the market did go up by 150% between June 2014 and early June of this year, so if you were in the market at the beginning, of course, you're probably still sitting on profit, so you could say that this is just a correction in what had been an extraordinary appreciation of stock values.

Merryn: Yes, I see you're not using the word bubble' there.

George: I was thinking about it. I prefer to think about the Chinese market as an experience in speculative euphoria. I mean, it's not a market in the way that we understand markets, in fact, I'd refer to this as the Communist Party's party, because I think that the fingerprints of the party are certainly on what has happened.

I mean, we could talk about a lot of things that have evolved over the last year or 18 months, including public rhetoric from the governor of the Central Bank and from members of the State Council about how good a rising stockmarket would be for the economy; the Hong Kong-Shanghai Connect scheme, which was hailed as one of the great innovations of financial reform. It's kind of designed to bring money via Hong Kong, or from Hong Kong into China, into the Chinese equity market.

The Chinese have done a lot to try and increase the perception of robustness in their own financial system.

Merryn: But why do you think it matters for them that that stockmarket goes up? Is this a reaction to the falling property market, an attempt to shift the wealth around? What's going on there?

George: Yes, I kind of see it as the equivalent of the way that we used credit in the 2000s to mask fundamental problems that we had about productivity and slowing growth. I think that in a very, very difficult economic transition in China, where you've got over-capacity and rising debt and debt is quite a serious issue I think asset price inflation, particularly to the extent that it makes the balance sheets of state-owned enterprises look better, and it encourages companies to shift their financing from debt to equity, I think this is part of it. This is why they would like a buoyant stockmarket. What I don't understand is why on earth authorities who have total control over the economy actually were so complicit in the use of leverage, particularly in allowing margin debt to grow from something like 200bn at the beginning of 2014 to now perhaps 1.7trn, 1.8trn.

Merryn: So they could have, and they should have, stopped this earlier, to make it more sustainable?

George: Yes. I don't understand why they even allowed it, but they did. That's something I confess, hands up, I'm not sure. But certainly now we've seen, amongst the kind of panoply of measures that the authorities have brought to bear to support the market, is the instruction to actually ease margin requirements, which is a bit head scratching, but there we are. They're obviously engaged in a huge support operation

Merryn: And you think they can do it? I mean, we've seen government attempts to support stockmarkets like this before, Japan being the one that springs to mind, and it doesn't really work, does it?

George: I mean, the only example that I can think of, really, is when the Hong Kong Monetary Authority, basically, in the Asian crisis bought the equivalent of about 10% of market value, outstanding market value, and I think they did push the market up, literally they stabilised it, and then it went on its merry way from there. I'm not sure that the Chinese authorities can do that; I think they have a lot of money they can still throw at it, but actually, this is not really a market, as I said, and I think that ultimately I have real issues with whether- The fundamental issue for me, really, is what it does to the confidence that people, and Chinese people in particular, have had in the state and government authorities to manage the market, and, implicitly, to manage the economy as well.

Merryn: OK, so you're not a buyer of the Chinese market at the moment?

George: No. I mean, there will be a vicious short squeeze at some point in the not too distant future, but I think this market is going back to where it came from, which is about the Shanghai composite.

There are some Chinese companies that are world class. But these are exceptions to the rule. The predominance of state enterprises in stockmarket listings is not something that fills me with enthusiasm

Merryn: Oh, you think it's going all the way down?

George: Yes, if you look at I mean, we really did have a bubble in 2006-2007, and then we had a crash, and then from 2007 until 2014, which included some of the best years of Chinese economic growth and SOE profitability, the market just traded like a pancake.

Merryn: But we know that there is no correlation between economic growth and stockmarket performance, right? It's based on valuations and money flows, so the fact that the market didn't move when growth was very high doesn't really tell us anything, but we do know that very often stockmarkets start moving substantially when growth in the relevant countries slows down. We have examples of that all over the place, because that's when companies start focusing on profitability etc, and when valuations start to look good. So you could suggest that that's been one of the drivers behind the Chinese stockmarket.

George: You could. I wouldn't.

No, I mean, I'm not saying clearly we know there are some Chinese companies that are basically world class, and are almost world brands now. But these are really exceptions to the rule, and the predominance, really, of state enterprises in listings actually is not something that fills me with enthusiasm. I don't really see SOE reform, which is one of the mantras that the Party basically keep waving in the reform programme, I don't really think there is- There are changes going on to executive compensation and compliance and efficiency, red tape and all this kind of stuff. But the idea of bringing private capital in to share ownership decisions and participation, these are just propaganda tools, I think, and there is not much going on.

Merryn: OK. Well, you mentioned briefly this very difficult economic transition for China at the moment, and clearly you don't believe that they can use the stockmarket to help them manage it. Do you think that they can manage this transition without crisis? This shift from being a very fast growing economy, based on low wages etc, shifting over to attempting to be a slow growing economy with a consumption bias is that possible?

George: Right, so there are two bits of good news here. First, the re-balancing, which is what the government clearly recognise as necessary, is going to happen regardless of all of the discussion and debate that we may have. The reason it is going to happen is because the investment rate in China, which obviously had reached almost 50% of national income, it does now look as though it's beginning to decline. Of course, as that happens, then, by definition the investment rate goes down, the consumption rate goes up. So that re-balancing is going to happen over time.

The thing that I think a lot of people and a lot of investors sometimes don't get, in my view, is that this can only happen in the context of significantly lower growth. It's not as though Chinese consumers have been slouches, sitting there with their arms folded and not consuming. We know that for some time real consumption growth has been running at about 7% or 8% per annum.

So, what has to happen, of course, is that investment growth has to slow to something that's below the rate of GDP, leaving consumption growth above it, and I think that will happen as the aggregate growth rate slows. It has been 11, it is seven-ish-

Merryn: Do we think it's seven, or do we think it's below?

George: Well, I think it's below, and we'll soon probably get confirmation that it's proving difficult to keep it up at seven, even on official measurement. But I think over the next three to five years it's going down to about 4%. Actually, it sounds awful, but it's actually not a disaster.

Merryn: No, and it's perfectly normal for an economy that has grown at that speed for that long to slow down into a consolidation phase. This shouldn't be a surprise to anybody.

George: It shouldn't be a surprise, but the change has already taken commodity producers from Perth to Peru a little bit by surprise, and I think it will take a little while for people to get used to the idea that China's growth rate is pedestrian.

Merryn: OK. Let's move over to the other crisis that we're all so interested in at the moment, which is the crisis in Europe, and the odds of Greece leaving the eurozone. Do you think that is likely?

Greece outside the euro would become a wonderful resort, attracting lots of tourists, but there is not much else in the economy, apart from asparagus, feta cheese and olive oil

George: Well, this week, of course, in the wake of the referendum, it's become pretty apparent that this is make or break now. So, on Sunday there is going to be an unprecedented double summit of the eurozone heads of state and of all 28 EU members, which I think is indicative of how serious the European leadership actually thinks this situation has become, and they're not just having a summit just to talk about Europe in general, they're clearly going to talk about what happens if there can be no agreement between Greece and its creditors.

So, I think, as I said, the default position now looks like it is that without an agreement Greece will not get any kind of third package, and Angela Merkel has already said that there is not going to be bridging finance. So then we will move quickly into a situation where the banks will stay shut, the ECB will have exceptionally difficult decisions to make about whether to maintain its liquidity assistance to Greek banks, or, come 20 July when a big payment is due to the ECB, if that payment isn't made, the ECB could quite easily, and very likely will, cut the lifeline, and thats' the end.

Greece would have to introduce a parallel currency, an IOU system, and I think that would be the beginning of the end, and exit would follow soon thereafter.

Merryn: OK, and what would that then mean, for Greece and, taking it further, for the European project as a whole?

George: Well, for Greece, it's a bit churlish to say it would an economic disaster, because the Greeks already feel that they're in an economic disaster, and it's kind of interesting that a lot of US and UK academics have been exhorting Greece to leave the euro system and make its own way.

I actually think, given Greek history and the difficult structure of the Greek economy and the absence of manufacturing, really, that actually life outside the euro would be a catastrophe. I mean, it's in a terrible situation now, but I think it would get worse.

Merryn: So it will become what, just a very poor holiday resort?

George: Yes. I mean, obviously the tourist industry would clearly benefit; people who have been going to Turkey, for example, would find- You know, one imagines the new drachma would drop by about 40%-50%, so Greece would become a wonderful Mediterranean resort, a cheap resort, attracting lots of tourists. But actually, there is not much else in the economy, apart from asparagus, feta cheese and...

Merryn: Olive oil.

George: ...its oil products, olive oil.

Merryn: But then you say that the new drachma would immediately fall 40%-50%, I mean, that tells us surely that what's happening here is that the eurozone simply doesn't work, that Greece has a currency that is the wrong price for it, and I guess Germany does as well. So this is less a crisis of sovereign debt than a crisis of competitiveness.

George: Indeed, but if you had this conversation with the Irish or the Spanish or the Portuguese, they would say, "Well, we've actually devalued but we've done it a different way".

Merryn: They've devalued internally, yes, but not to the extent that Greece has to. Greece is in a worse position than those economies, and they have also suffered phenomenal pain by internally devaluing, and by internally devaluing' of course we mean cutting wages etc, etc, but Greece is in a worse position, as you say; it has a very little to offer as an economy, and that kind of internal devaluation is very difficult to deal with, socially, as we're seeing.

Monetary unions that work, like the United Kingdom, the United States, or the Federal Republic of Germany, work because they have been preceded by political union

George: It is very difficult, and it's very painful, and some would say, very unjust. It's kind of one of the rules that goes along with monetary union, though, in much the same way as in this country, in the United Kingdom, we have huge regional disparities.

Merryn: Absolutely, but we transfer vast amounts of money to those regions, so the monetary union system doesn't work without the transfers, and the rest of Europe is clearly unwilling to provide the regular transfers to the peripheral states that are required inside a proper monetary union. So it's failing on that basis.

George: Which is the key point, which is that monetary unions that work, like the United Kingdom or the United States, or the Federal Republic of Germany, they work because they have been preceded by the political integrations, the political union that enables those transfers to happen. So this is a unique experiment of trying to put the cart after the horse, which is to do the monetary union and then to do the political union. Now, we know that was flawed, and we can see now that it doesn't work, particularly where a country, in this particular case, Greece, has real problems with implementation. Spain, for example, hasn't had that problem, but Greece does. So, what this now reveals is that if Greece leaves the euro system that the euro isn't really a single currency, but it's a system of fixed, but breakable, exchange rates, which means that even if the whole feared contagion is contained now, in a future crisis it might not be, particularly if a big country like Spain or Italy were involved.

So, the acid test for Europe now is can it seize this moment as an opportunity to persuade sceptical citizens that this is the time for greater integration: discuss.

Merryn: Yes, well, to me that seems incredibly unlikely, and it would seem to me that what we're seeing now is less willingness on the part of the various European countries to politically integrate, not more, or the willingness to bail out Greece would be there, and it isn't. If the core of Europe really wanted to be in a proper political union with the periphery of Europe, they'd be signing the cheques, and they're not.

George: Yes, I concur. I mean, I'm afraid that is the way that it looks, and that might mean one of two things, either that in the future more countries or a country, or more countries, might actually leave the euro system. In extremis it might mean that the whole thing just blows up and we go back to national currencies all over.

Merryn: Would that be a bad thing?

George: As we sit here thinking about it, it feels pretty traumatic to me, because actually, of course, the whole of the last 60 years, actually, since the European Coal and Steel Community was founded in the 1950s, the European agenda has always been about integration and closer co-operation and so on and so forth, and for the first time since the end of the Second World War, we're now looking at the prospect of disintegration.

The Greeks want one thing, the Germans want another, they can't co-exist inside the same union. It's a kickback of democracy

Merryn: But is what we're seeing here the idea of ever closer integration, ever closer political union etc and I know this is much talked about, but I think it's very valid is it's very undemocratic, we're moving towards an area where people are perhaps beginning to rebel against the undemocratic nature of international organisations such as the EU etc, and you can see the whole Greek situation in the context of a clash of democratic mandates, you know, the Greeks want one thing, the Germans want another, they can't co-exist inside the same union. It's a kickback of democracy.

George: Right. Well, here is a nerdy thing to think about, but actually is really important, and actually I invoke here what a professor at Harvard, Danny Roderick, called a "globalisation trilemma" he formulated this several years ago. Just imagine a triangle and label the points of the triangle: economic integration, national sovereignty and democratic politics.

His argument is you can only ever have two of these three, unless you have trusted, respected institutions to integrate them altogether. That's really where Europe has been found out, actually, is we don't have the trusted, efficient institutions. So this really is a kind of make or break time, actually, because you can see from populist unrest and the rise of anti-EU parties and so on, and regionalism, that people are basically saying, "Actually, this kind of national sovereignty, democratic politics malarkey is actually something that we care quite a lot about."

Merryn: Yes, we liked that.

George: We like that. So, I kind of jest a little bit, but actually the challenge really is to bring these If Europe is going to succeed in the future, they have to bring these three back into some kind of respectable balance.

Merryn: Let's talk more about these institutions that we don't trust. Possibly one of the things that we're seeing in Europe at the moment as well is that the ECB just can't do everything. We've rested enormous power now on our central banks, we've basically handed over economic management to our fiscal authorities to our unelected monetary authorities, and asked them to get on with it. We can see, in Europe and possibly in China as well, that actually they can't do this by themselves without the fiscal authorities stepping up to the plate as well. The central bankers, we're asking too much of them, and they can't do it.

George: Yes. I think that's absolutely right, I think we have asked far too much of central bankers. Or, if it hasn't been, kind of, you know a conscious act of request as it were, I think the government's basically turning a blind eye or being inert or actually not stepping up to the proverbial plate.

Merryn: Yes, I mean you can say that, you know, our central banks, we give them legal mandates that they have to fulfil for inflation, employment, whatever, depending on which bank we're talking about, and if the elected authorities, the fiscal authorities don't create the situations themselves, the central banks have to do it.

Ultimately it's very clear that if we leave things as they are, then our central banks will become the fiscal agents of the government

George: Yes, they do, and actually there is a kind of well it is a grey area to an extent but actually ultimately it's very clear that if we leave things as they are, then our central banks will increasingly become, if not already, the fiscal agents of the government. So, you only have to imagine what happens in the next economic downturn whenever that might happen, when interest rates are zero or a half percent, or whatever. So, the central banks won't have any kind of monetary ammunition with which to stimulate the economy and so we'll have new versions of quantitative easing, whatever they might look like or be labelled, but in effect, the most efficient way with which the central banks can then make their policies then work in the economy, is in effect to buy government debt directly without taking it from the banks.

Because when they print money by so-called print money by swapping bank balance sheets by giving them buying the securities and giving them the cash, I mean it relies on the banks to distribute the cash.

Merryn: To create their own money.

George: To create their own money, which of course there are structural problems in doing because of regulatory constraints on banks and because loan demand isn't all that strong and so on. But, you can get round this and people are obviously expecting at some point that you can get round this, by having the government spend the money directly, so it sells assets, it sells bonds directly to the central bank. Government gets the money; what does the government do with the money? Spends it.

Merryn: Yes, so this is when you get the big infrastructure boom that you would expect at some point in a crisis cycle like this.

George: Yes, and then independent central banks is basically an anachronism. Then the central banks really are the fiscal agents overtly fiscal agents of the government, and then you have to have a discussion as to whether that's exactly what you thought you wanted central banks to do. So, if that happened, you know, I think we would ourselves be to blame for having allowed governments off the hook, and as you say, put far too much weight on what central banks were able to achieve.

Merryn: Yes, now you talk about interest rates going lower and lower in the next crisis, there being nowhere to cut to; do you have any sense that we're coming to the end of this kind of 30-odd year fall in interest rates that I mean there has to be a turn in this cycle, right, interest rates can't go too far below zero, so at some point interest rates have to start turning back up again, and that of course changes the dynamics of the whole global economy; but when does that happen?

George: Well I mean in Japan and in Europe it's not going to happen for quite a long time, we know BOJ [Bank of Japan] is still in the process of doubling its balance sheet. Mario Draghi has told us that the ECB will do QE until September 2016 and so on, but I think in the US and the UK it's different, so we've kind of decoupled a little bit from within the developed world. And of course the big focus really is on the United States and when, and if, policy rates might start to go up, and everybody knows the expectations that it might be in September, it might be in December. So, I want to take a slightly optimistic view on this, which is that after a terrible start to the year, the American economy does seem to be regaining a little bit of momentum.

And over the summer, if that continues, which I don't see any reason why it shouldn't, to be honest, and if we start to see further evidence that fuller and fuller employment is beginning to have some traction with regards to wages and salaries, then I think, you know, the Fed will find the wherewithal to bite it's bottom lip and say, "We want to do this, we're a bit scared about it, but actually now's the time to start."

Merryn: Better get on with it.

George: And I think they will do that. Of course there's a subsequent question about how far will policy interest rates rise over the next couple of years? And that may not be very far.

Merryn: Do we have to worry about inflation at all? Because at some point, inflation has to make a return.

George: Right, are you asking me the question now and I say no.

Merryn: Yes.

George: If you were asking this question in 12 months' time, you know, it might be a different answer; I might say yes, because when that happens I think it will happen quite quickly and unexpectedly.

Merryn: Oh, interesting, and what will make it happen?

George: Well, the first thing that's going to happen, I think, unless there's another precipitous to climb in the price of oil and energy, is in the fourth quarter of 2015 and looking into the first half of 2016, consumer price inflation rate will go up quite significantly. So, that's what we call in the trade the base effect, right, so that doesn't necessarily mean that there's a kind of an endemic endogenous inflation going on, but actually if that happens at a time when we are we start to see wage settlements and earnings start to kind of ratchet up, bit by bit.

Merryn: Which we are seeing already aren't we? We're seeing settlements.

George: In the US and the UK it is starting to happen a little bit.

Merryn: And in Japan.

George: And in Japan too, yes. So these are early signs, I don't think we want to get carried away with it just yet, but I'm just saying, when it happens, it could happen when people are kind of looking the wrong way.

Merryn: OK, so we're in a really dodgy environment here, all round, what do we do with our money? What do you do with your money at the moment?

George: What do I do with my money? I'm not a very good investor.

Merryn: That's not the answer we want.

George: No, it isn't. Look, I think like a lot of people, I kind of got rid of all the bonds that I held during the financial crisis a year or two years ago.

Merryn: That makes you sound like a good investor to me.

George: No, just lucky, really, I think. I mean I just thought that there's no point in hanging onto I mean I got rid of the bonds not really being very confident about what equities would do, but then I kind of sort of fell in line with the view that, "If central banks are going to keep exceptional easy monetary policies in place and interest rates are zero and cash is as cheap as chips, then there's only one place to be which is stocks.

Merryn: Only one place. Not Chinese stocks though.

George: Not Chinese stocks, but that's where I am and I think if and when the market turns or it just starts to stagnate, I will probably be too late, but I just think for the time being it is the asset of choice, or by default, and I think we just have to kind of watch that interest rate environment. If it looks like markets are beginning to discount, I won't say even a normal policy cycle because I think most people think that there's nothing normal about what's going on at the moment.

Merryn: No.

Technology and healthcare are the kind of bog-standard things that should do really well in the future, because there are huge opportunities and explorations going on which will bolster our productivity over the medium to longer term.

George: But if the markets start to discount the fact that when the Federal Reserve starts to change interest rates that there might be sequential increases in interest rates, you know, not rapid, not aggressive but sequential, then it will create uncertainty in the bond market and I think that will cause equity markets to stall a little bit actually.

Merryn: OK so you're not really giving us any good news here but we're used to that so

George: The thing is, here's something that I take a little bit of comfort from.

Merryn: OK, good well let's end on a piece of good news.

George: Yes, well it's kind of good news/bad news. So, one of my passions

Merryn: Let's consider it actual good news.

George: OK, so one of my passions is demography, right, I'm very interested in what this unique experiment in mankind and womankind is where it's leading us. And of course one of the big economic

Merryn: When you say this unique experiment you mean

George: Well not experiment, but the experience of rapid ageing.

Merryn: The experience of rapid ageing, OK, yes.

George: So, the implications is that more and more over time we will experience labour shortages and skill shortages because there aren't enough kids growing up to become workers as we all go to the great retirement home in the sky and so on and so forth, but what that means is that the relative rewards to labour will go up in relation to capital, which means that what it really means is it doesn't mean to say that stock prices drop, but it means that equity returns will not be as big as they were in the past. So, if we have had over the last five years, stunning equity returns for reasons that are related to QE and zero rates and so on and so forth, we must expect that over some period of time in the future that those returns will become more modest.

Merryn: I'm struggling with the good news here George.

George: Well, the good news is that stock prices won't go we won't necessarily face a stockmarket crash, but actually we should be prepared for well, we should be prepared for more modest equity market returns, but of course within that, you know, there are going to be companies that will do extremely well. So, you know, you can look at I mean I'm not a stock picker but I think

Merryn: Oh go on, give us one anyway.

George: Technology, healthcare, I mean these are the kind of bog-standard things that people think, well they should do really well in the future, and I think they probably will actually because there are huge opportunities and explorations going on which I think will come through to, here's the good news actually, bolster our productivity again over the medium to longer term.

Merryn: Well that would be good, George thank you very much.

George: Thanks.

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.