This weekend, European Union leaders get together to discuss the idea of a eurozone-wide post-coronavirus recovery fund. It promises to be a heated debate. The amount of money at stake isn’t actually that high – but the points of principle being discussed are potentially transformative for the region.
Describing the summit as “make or break” would be entirely inaccurate, as these things never are. There’s almost always one more summit, or one last-ditch effort. So I'd ignore any overly-melodramatic headlines that are generated. However, do be aware that this matters for markets.
Why? Here goes.
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The risk of a eurozone break-up has been hanging over markets for years
A eurozone break-up is seen by the market as an event with low probability but a big impact (“tail risk” in the jargon). It’s also a risk that has hung around in the back of the market’s mind ever since the financial crisis.
There’s a good reason for that. At this point in time, there are not many events that could result in a repeat of the 2008 financial crisis. Central banks (America’s Federal Reserve in particular) are 100% committed to standing behind the financial system and doing “whatever it takes” to stop banks going bust. The reaction to Covid-19 has confirmed that beyond any doubt.
Lehman Brothers wouldn’t be allowed to go bust today. The Fed would have reacted as soon as the credit crunch started up a year earlier. So, in truth, not even Northern Rock would have been allowed to go bust.
The only way we could have a repeat of that specific deflationary credit crisis scenario is if central banks were unwilling or unable to act. They’ve made it clear that they are willing. So what would render them “unable”?
A breakup of the eurozone is quite possibly the only obvious scenario that fits the bill. The legal, financial and economic mess created by the demise (or threatened demise) of the single currency would be too much for any central bank to deal with.
This is the reason why a country as relatively insignificant to the overall global economy and financial system as Greece (please don’t take that as an insult – it’s a statement of fact rather than a value judgement), could have the entire world on the edge of its seat for literally years at the start of the 2010s.
Greece was eventually “solved”. The big threat, more recently, became Italy, which has suffered from low growth ever since it joined the eurozone. We won’t go into the whys and wherefores of that just now – I’ve done it before and it’s not important to the topic at hand.
But the result of this weak growth and rolling economic crisis in Italy is that it has created the (currently small) risk that an explicitly anti-euro political party gets voted in and decides to take Italy out of the single currency.
The problem is that Italy is both one of the world’s biggest economies and also one of the world’s biggest government bond issuers. That’s because it has a lot of government debt. Ultimately, the eurozone could likely carry on after a Greek exit, as long as the process was smooth enough, even if it involved sovereign debt default.
But an Italian exit? Forget about it.
So this “tail risk” has been hanging over markets for ages. Every so often it rears its ugly head. For example, in the run-up to Mario Draghi stepping down as European Central Bank (ECB) boss, markets got jittery again. Draghi was seen as the guy holding everything together – could his replacement do the same?
Draghi was well aware of this of course, and so he made sure that he left the ECB with a full toolkit that basically made it the same as the Fed and the Bank of England – it could print money virtually with impunity (German court challenges notwithstanding).
A politician – Christine Lagarde – then took over the ECB, and has been left with the job of pushing through fiscal integration.
As we’ve mentioned many times before, you can’t have a currency union without also eventually having a transfer union. In other words, if you want to share a currency, then money also has to be able to flow to the areas that will suffer as a result. Or to put it even more simply, the most productive bits have to subsidise the least productive.
When that involves crossing a country's borders, it gets tricky. For example, German exporters benefit from sharing a currency with Italy, because it means the currency is weaker than the deutschemark would be, so they can export more. But telling a German taxpayer that this means they have to pay for Italian infrastructure spending as a reasonable trade-off, and you might struggle to sell the idea.
And, at the risk of oversimplifying, that takes us to where we are today.
What’s at stake as the EU meets up today?
The EU summit is running today and tomorrow and it’s all about agreeing on a European Recovery Fund. The idea here is to create a pool of money to help the post-coronavirus recovery across the region (the exact figure isn’t agreed – between €500bn and €750bn).
But the big issue isn’t really the amount as such. The big issues are as follows.
Firstly, this money would be borrowed by the European Commission – in other words, the eurozone would be issuing common debt, backed by all EU member states (so to be clear, this includes the non-eurozone EU members).
That’s never happened before on this scale. On the one hand, it is being sold as a one-off. By this argument, it’s not really fiscal integration. On the other hand, nothing is so permanent as a temporary government programme, as Milton Friedman used to say.
Secondly, some of it will be in the form of loans (it’ll need to be repaid). And some in the form of grants (it won’t need to be repaid). The question here is: how many strings are attached, and how do you find a compromise between the countries who want the money (and therefore don’t want the strings) and those who’ll be providing the money (and so want as many strings as possible).
Germany and France, the key players, are onboard, which is important. But some of the more fiscally sound countries – the “Frugal Four” of Austria, Denmark, Sweden and the Netherlands, two of which are non-eurozone countries – would prefer loans to grants, and would prefer “troika”-style conditionality.
You may have (mercifully) forgotten by now, but the “troika” became a by-word in Greece for fiscal repression and austerity. You can argue about the fairness or otherwise of that characterisation 'til the cows come home.
But either way, if you think Italian voters are going to go for this option, then please do save me some of whatever it is you’re drinking on this fine sunny Friday morning.
Why this matters for you
Anyway – this has been a long read this morning, so let’s cut to the chase.
Markets really like the idea of a joint fund being pushed through. A step closer to fiscal integration means a step away from a messy break-up for the eurozone. And at least one of the big drivers of the ongoing rally has been the hope that this is a catalyst for Europe to get its act together.
The reduction in “breakup” risk not only removes a big deflationary tail risk from the table – it also makes the euro more appealing, which in turn means the dollar gets weaker. A weaker dollar is good news for most risk assets, as all else being equal, it means money is getting cheaper for everyone.
So if we come out of this weekend with a big bust-up and no sign of a deal, markets would not like it. If we come out with no deal, it depends on the mood music. Markets are used to European affairs taking their sweet time, so while it would be disappointing for investors, it’ll probably pass as long as there are positive murmurings.
If we do come out with an agreement to issue common debt, then the good cheer with which markets greet this depends on the amounts and on a sense of the "loans vs grants” question.
What I would point out is that markets have had a big run-up in the lead up to this summit, and so a reasonable assumption of success is already baked in.
For most of you, this is not especially impactful on your day to day investment lives – it’s just useful to know about, as any disappointment or lukewarm deal could be a trigger for a correction. Which is why you should be brushing up your watch list right now.
If you are the sort to be trading currencies (not something I recommend, but you’re adults) then you should be aware that this is the sort of thing that could have an impact come Monday morning, so be (even more) careful out there.
Whatever the result we’ll have more about it in MoneyWeek next week – subscribe here to get your first six issues free.
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