In the late 1950s the leading European nations started developing the concept of a strong Euro trading region to compensate for the waning global power of the area.
Their ideal scenario for the Euro project was firstly to establish close trading partnerships between European nations unburdened by borders and tariffs, followed by a common currency to overcome interest rate barriers and then on to fiscal union where we would have common policies on little things like taxes and social welfare. Finally this would all be topped off with Political union, leading to the Federal Superstate so coveted by Europhiles and so feared by the Brits.
The major flaw here, as accepted by many respected commentators, is that this ideology ignores the fact that we are not all the same. We are not all as prudent as the Germans, passionate as the Italians, great vintners like the French or as profligate, allegedly, as the Greeks! The herding cats metaphor comes to mind.
Winners and losers
After all these years it is only really the first part of the project that has been achieved with open borders to trade within the EU. Part two, Economic and Monetary union, has been partially introduced with 17 member states using the Euro. However the EC bureaucrats in Brussels continue to struggle to get buy-in to their rules and regulations, particularly by grudgingly compliant countries like the UK.
Currency union has been great for the industrial powerhouses, like Germany, seeking to export large quantities of their top quality products around the world at competitive prices.
However, the peripheral nations, for example Ireland when ‘Riding the Celtic Tiger’, have enjoyed fantastic periods of growth due to their ability to borrow large sums of money at the competitive rates available to them pre the 2008 banking crisis. At this time the world financial markets felt there was an implicit guarantee on Eurozone member bonds from the ECB/Germany. This created a false impression of wealth for the Irish via a property bubble, which then enabled successive governments to adopt very generous Social Welfare policies thereby currying favour with the electorate. Instead of banking their profits (no pun intended) and building up the strength of their balance sheet, they borrowed more and this eventually led to their downfall. A very familiar story to that of Greece and the other Southern Europeans!
The problem
There is a strong argument that this profligacy of the smaller nations in the good times has been the major contributor to the Eurozone crisis. The flaws in the concept were covered up by the highly leveraged excesses of the last decade, and the apparent successes of the peripheral countries were always built on sand. When the markets turned, following the 2008 banking crisis, asset values collapsed and business and consumer spending slowed to a virtual standstill. As government income fell, their debt burden increased as highly efficient markets pushed up bond yields, and therefore interest rates, to unmanageable levels.
As a consequence, the people have spoken in many of the Euro Countries; Slovakia, Ireland, Greece, Portugal, Italy, Spain and France have all seen changes in governments. The Germans are governed by a coalition and have an election next year. In the UK the coalition government has just lost a crucial commons vote relating to our contribution to the EU – and the proposal was for no increase. Hardly a ringing endorsement!
To use a European sporting analogy, it is like entry to the Champions League being thrown open to Forest Green Rovers of the Blue Square Premier League and then giving them a cheap loan to buy Lionel Messi from Barcelona such that they can try and compete with the big guys and satisfy their small band of supporters. Could it be argued that this strategy might be flawed from the outset?
The potential solutions
Unknown consequences. Potentially very unpalatable to all – both inside and outside the club!
In particular, a breakup of the Eurozone would not be good for the Germans. If this happened and they returned to the Deutschmark, it would likely have a significantly higher value against other currencies than they currently enjoy with the Euro. This would of course have the effect of making their products more expensive to other countries, thereby curbing their export capability and making them far more reliant on a culturally prudent domestic market Very difficult!
2.More funding, debt write off and a changed model
For the past couple of years many stakeholders and commentators have been clamouring for the ECB to step in and act as the lender of last resort to the distressed nations. This is on the basis that it should have the effect of reducing their borrowing costs, increasing their competitiveness, and lead to greater stability.
Germany have remained staunchly against this, on the basis that it would in effect be the European Central Bank printing money which, as we know, is likely to be inflationary, and that they would be the major contributor. It seems there are deep rooted German legacy issues here with close memories of the hyper-inflation created by the 1930s Weimar Republic prior to WW2.
The stronger countries would demand a say in the running of the smaller countries to make sure they stuck with their austerity plans. Of course the weaker nations don’t like this. Back to the flaw in the concept.
Notwithstanding all of this, the last 12 months have seen two significant interventions from the ECB:
- December 2011 – Long Term Refinancing Operation (LTRO) The ECB announced the much anticipated LTRO, with 489bn euros of three-year loans to the Eurozone’s banks. Whilst this calmed markets for a time, there was so much uncertainty around at the time, that you had banks borrowing from the ECB at 1% and then lending it back to the ECB overnight at 0.25% to make sure the money was both accessible and safe!
Robert Peston of the BBC wrote an excellent article explaining this.
2. September 2012 – Bond buying programme
On 6th September, Mario Draghi, the president of the ECB, defied German opposition and launched an “unlimited” bond-buying programme.
Mr. Draghi said the action, called Outright Monetary Transactions (OMTs), would “enable us to address severe distortions in government bond markets” and provide a “fully effective backstop to avoid destructive scenarios”. He added: “The euro is irreversible.” Stock markets soared and Spanish, Italian and Portuguese borrowing costs were pulled sharply lower.
The big issue here is that countries have to ask for help. The Spanish are doing everything they can to NOT ask for help, as they fear the level of further austerity cuts and regulation that would be forced on them by the ECB (back to the flaw in the model).
Summary
Mario Draghi seems to have played his limited hand well. Italian and Spanish 10-year bond yields are both now well below the dangerous 7% level. The Euro STOXX volatility chart is now at around 23, having peaked at 43 in December 2011.
German intransigence has seemingly receded, as illustrated by the approval of their top Court in September of both fiscal union proposals and the new European Stability mechanism, albeit with a cap on their contribution.
Ironically, a mix of political expediency by Angela Merkel to calm her coalition partners, a German slowdown in GDP, Spanish and Greek civil unrest, and a fear of the unknown (i.e. what happens if countries start leaving the Eurozone) have led us to this relative period of calm.
However, most analysts believe the problem has been subdued, rather than resolved. If the basic model is flawed, it could be argued that however much money you throw at it, the problems will resurface at some time in the future. It is akin to the many businesses in the UK described as the ‘Walking dead’, only alive due to artificial life support, and the problems will only ultimately be resolved with some major surgery.
The problem is that with so many stakeholders with diametrically opposed agendas, it is difficult to see us reaching that point until we experience a further major Eurozone, or even Global, economic catastrophe!
Last thoughts
My biggest concern about the 2008 banking collapse was always the Moral Hazard issue.
In a free market economy, when organisations fail for whatever reason, there are mechanisms in place to carry out an orderly disposal of available assets. And the capacity that this failed entity was soaking up is distributed to other suppliers. The shareholders of the organisation, who took a risk to invest on the basis that it might be the next Microsoft or Apple, lose their money.
The effects of the failure to implement these mechanisms in both the global banking community in 2008, and in the Eurozone over the past few years, will be felt for many years to come.
