Quick thing before I get started this morning – if you want to hear about truly radical solutions to the economic mess we find ourselves in right now, then have a listen to Merryn’s podcast with Professor Steve Keen, freshly recorded yesterday. I guarantee you’ll find it interesting even if you don’t buy into the ideas. Have a listen now!
Anyway, I wanted to have a quick look at the eurozone this morning. French president Emmanuel Macron is on the front page of the Financial Times this morning. The headlines have him warning that the “EU will unravel” unless it “embraces financial solidarity".
So what’s he talking about, is he right to be worried, and what does it mean for the rest of us?
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Here’s what the latest eurozone conflict is all about
Let’s try to keep this relatively simple. Europe, along with everywhere else in the world, is in the midst of a crisis caused by the coronavirus. But unlike everywhere else in the world, Europe also has the added problems caused by the existence of the euro.
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The EU itself could exist as a trading bloc and a bureaucracy throughout this crisis, and continue to survive in its wake without really ever getting involved. Individuals in individual nations might think it should have done more (or less) but at no point would its existence come into question.
The issue is the euro. When a country joins the euro, it gives up the ability to manage its own currency and, along with that, a big chunk of the ability to manage its own economy. That means you can easily end up with an exchange rate that is too high for your economy.
Simple example: in the olden days, Italy had the lira. When things went pear-shaped, Italy would inflate its way out with a weak currency. It’s not the way I’d choose to run an economy, but that’s what worked for the Italians.
Now Italy has the euro, which is something closer to a weak form of the deutschmark. You can’t have an Italian economic model with a German currency. It doesn’t work.
As a result of all this, Italy is up to its eyeballs in public debt (not so private sector, but let’s not worry about that for today). It’s getting on for 155% debt to GDP. That means investors are wary of buying its government debt because they don’t think Italy will be able to pay it back. The only reason they do buy it is because, fundamentally, they think that Germany is in some way standing behind this debt too.
And they’re kind of right. The European Central Bank (ECB) is now, for all practical purposes, a fully-fledged central bank. It can print what it likes to buy what it likes. The previous boss, Mario Draghi, saw to that.
But politically, under Christine Lagarde, it’s still a little tentative. Hence, the spreads (the gap between the borrowing costs of “northern” countries like Germany and “southern” countries like Italy) have remained elevated.
There’s also another fundamental problem here. It’s not very democratic for a central bank to be – in effect – transferring money from one country to another by the backdoor. That’s something that voters need to agree to, which means that governments need to be involved.
Basically, it’s all about that grey line between fiscal (directed public spending by democratically elected governments) and monetary (day-to-day economic management by technocratic central banks) policy again.
So, at the moment, European leaders are trying to figure out how to set up a common fund from which to dish out money to the countries hardest hit by coronavirus. And that means issuing debt backed, not by individual governments, but by the eurozone as a whole. Which means that Germany (or in this case, the strongest objections are coming from the Netherlands) is on the hook for Italian debt.
Which way will the eurozone go?
Just to be clear, I genuinely have no preference for which direction the eurozone evolves in. With Britain out of that particular loop, I have no dog in this fight.
If the eurozone nations desire ever-closer political union, culminating in a core “United States of Europe” then that’s fine. If they’d rather return powers to individual nation states, then that’s fine too (although it would involve breaking up the euro, which would cause a massive headache for all of us). So I’m trying to look at this from a practical point of view.
On the one hand, the idea of ever-closer union seems impractical. While it’s hard to get an accurate idea of how the populations of various nations feel about the EU as a whole, I think it’s probably fair to say that outright euroscepticism is mostly lower than in the UK.
However, that doesn’t mean that everyone is also itching to throw away the idea of the nation state in favour of a federal Europe. I don’t think your average voter would buy into that idea. Especially as it immediately makes it very clear that your German taxpayer will be liable for the retirement benefits of your Italian taxpayer (which also, in reality, then means that the benefits accruing to your Italian taxpayer have to start to converge with those accruing to your German taxpayer, which the Italians won’t like either).
So a transparent move towards federalism is a no go. It would simply be too unpopular with domestic voters in certain northern countries.
However, as a wise man said, breaking up is so very hard to do, and it's much, much harder when you share a common currency. Regardless of how they might feel about their fellow eurozone members, most voters would rather not go through the upheaval of changing back to another currency.
Greece provided proof of this back during the eurozone crisis, when it nearly became the first country to leave/get thrown out of the eurozone. It didn’t happen, because while the Greeks didn’t want austerity, they didn’t want the drachma either. So they ended up with austerity and a depression instead.
There isn’t the same urgency now as there was in the Greek crisis of the early 2010s, but only because the ECB can now print what it likes to stave off a crisis. However, the ECB can’t be the permanent backstop.
So where do we go from here?
To be clear, Macron is pushing for ever-closer union, because France falls firmly into the southern alliance. It’s hugely in debt – indeed, as financial historian Russell Napier has pointed out on a number of occasions it’s actually in a worse state than Italy in many ways (Russell spoke about this very topic in the MoneyWeek conference in November last year – have a listen to it here). (Macron is also using it as a distraction from problems at home, but it was ever thus with the EU – our own politicians used to do that too).
But at the same time, fiscal burden-sharing (ie, closer political union) is the only logical option if the euro is to be retained.
When faced with these questions I always try to look at the path of least resistance. A eurozone break up would be too painful – voters would rather avoid that. So I suspect we’ll just get a creep towards some form of shared debt.
But of course, that in turn then ramps up the risk that you’ll get a full-on backlash in one of the northern countries and that they might even leave the euro (the Netherlands is one potential example of this). That said, an exit by a creditor country would be less disruptive than one by a heavily-indebted southern country.
So that’s what I imagine will happen in the longer run. You’ll effectively have a eurozone that is run in the interests of the southern contingent, with the northern contingent either putting up with it (Germany, probably) or leaving altogether and returning to their old currencies (possibly the Netherlands).
But we’ll see. From an investment point of view, it does mean that for now I’m not overly worried about a sovereign debt crisis in Europe simply because I think it’ll be paid for with printed money, whatever happens.
That’s another reason to worry longer term about inflation, which is the topic of this week’s cover story in MoneyWeek magazine. Do subscribe now if you haven’t already.
