Europe has spent a lot of time wrestling with how to deal with the fallout from the Covid-19 outbreak and resulting shutdowns. Yesterday, after much wrangling, European Commission president Ursula von Der Leyen announced a €750bn rescue plan.
These days, admittedly, any number announced by a government that doesn’t have “trillion” appended to it just doesn’t look that impressive. But this is a bigger deal than it looks.
How the EU’s Covid-19 plan could change everything
The key here is how the EU proposes to pay for its €750bn Covid-19 scheme.
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The European Commission will borrow the money from financial markets between 2021 and 2024. This money will be paid out to the hardest-hit countries – Italy and Spain look set to get the most – while, as Ferdinando Giugliano puts it on Bloomberg, “Germany will receive relatively little”.
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About €500bn will be grants (that don’t have to be paid back) and the rest will be loans. The debt will be repaid with EU-wide taxes (spread over several decades).
The details of the deal still need to be thrashed out in the middle of next month. Not everyone is on board, and agreement needs to be unanimous.
But Germany, France, Spain and Italy are all behind it, which suggests that some form of this deal will go through.
Why is this a big deal? Because as Cedric Gemehl puts it on Gavekal, “at the end of the process, they will likely have established a precedent of the EU itself issuing common debt to leverage its budget. Thus, for the first time Brussels will be able to adopt public-deficit spending policies”.
So the point is not so much the amount – which is very small compared to other developed countries’ spending. It’s the principle. In particular, you have Germany agreeing to “burden share” – in other words, have German taxpayers pay to help out taxpayers in Greece or Italy, for example.
This is a big deal. I’ll explain why below. But just before we get onto that, I’ll state again that I have no strong political view on the eurozone. I think it’s somewhat impractical, that it lacks the democratic accountability necessary to give it full legitimacy, and that it has held some countries back.
But as long as the UK isn’t part of it, none of this is particularly my business. It’s up to the nations and electorates involved to advance as they see fit. And for as long as the voters continue to accept a march towards federalisation, it’s clear that this is what’s on the cards now.
So park your feelings about anything to do with the EU, the eurozone, Brexit, all the rest of it. There’s nothing wrong with having political views, or having strong views on what you think “should” be happening.
But when you’re trying to manage your money, you need to focus on what is actually happening and then invest accordingly.
Why this matters for investors
So what does this mean for investors? What really matters here is that it now appears highly unlikely that the eurozone will collapse “by accident”. The only way the eurozone is going to fall apart now is if an explicitly anti-euro party takes power in one of the core nations and campaigns to leave.
Why does that matter? For investors, the most significant point here is that, in the wake of the financial crisis, the eurozone has continued to represent one of the biggest potential deflation risks in the world.
A break-up of the eurozone would be the closest thing to a repeat of Lehman Brothers that we could face in the post-2008 world. It would trigger lots of hard-to-answer questions about who owed what to whom, and in what currency.
Central banks would try to paper over the cracks but it would be a massive blow to financial systems across the globe. It’s the one deflationary shock that I believe would be hard for central banks to deal with right now (or at least, it’s the most obvious one).
Now, however, we have a eurozone with a central bank that has virtual impunity to print money to underpin its banking system. And we have the biggest players basically agreeing to the principle of burden sharing on the fiscal side.
As Gavekal's Gemehl puts it: “By investing political capital into the EU’s response to the Covid-19 crisis, Merkel, Macron and the Commission have singled that the EU remains set on a muddle-through toward economic integration rather than disintegration. This should help ease investors’ concerns about euro risk assets."
Of course, lots of voters in various different countries won't like this. If they aren’t on board with the idea of a federal Europe (and many aren’t), then we can expect to see more upheaval on the political side of things. However, if that happens then we will at least get plenty of warning about it.
Perhaps more to the point is this: the countries now motivated to leave will be the more economically successful ones (ie, the ones who feel they are taking on most of the “burden” under the euphemistic “burden sharing”).
So, rather than the risk of seeing Italy re-denominating all of its debt (and there’s a lot of it out there in government bond markets) into lire, there’s the risk of Germany taking its ball back and promptly seeing most of its debt revalued higher with the return of the deutschemark.
In short, the biggest deflationary threat on the near-term horizon – a collapse of the eurozone – now looks to me, highly unlikely to happen. In turn, that makes me more convinced than ever that the denouement of this particular cycle is inflationary.
We’ll be writing much more about this in upcoming issues of MoneyWeek magazine. Now’s a good time to subscribe – our 1,001st issue is out tomorrow, and you get your first six issues free when you sign up. Plus a free ebook on some of history’s biggest crashes (as well as some of the least well known). Sign up now.
