With all that is distracting commentator’s attention there is one issue that is travelling below the radar, but if in years to come we look back on the Covid 19 era and the final months of President Trump’s tumultuous reign, the success or failure of the European rescue package could prove to be the more momentous outcome.
The EU has a regional policy of sorts and the various grants and subsidies funded from each member state’s contributions are distributed centrally by the European Commission according to the EU’s priorities. Research is conducted, farmers are subsidised, regional development projects funded, and those countries that make large net contributions justify these payments to their electorates as an annual club membership fee in exchange for economic, political and social benefits. However, when the EU’s budgeted expenditure and individual member state contributions are negotiated every seven years there are the inevitable squabbles between member countries – and likely more so in the forthcoming discussions now that one of the largest contributors has left the EU. Even before the pandemic piled deflationary pressure on the Eurozone economies, countries such as Italy, with stagnating economies and high structural unemployment, were already restless and impatient with their inability under Eurozone rules to borrow and to provide much needed support for their domestic economies. The underlying weakness in the Eurozone’s structure was therefore already exposed.
With its own currency the UK can borrow what its economy needs, and the supply and cost of government debt to support the UK’s economy are limited only by investor’s willingness to fund it through the purchase of government bonds. Italy no longer borrows in Lira, it borrows Euros. The good news is that Euros are cheap to borrow because there is a tacit German guarantee that supports the value of the common currency. Borrowing in Lira would have been very much more expensive as investors factor in the risk of struggling economy being unable to service and repay its debts.
However, there is no such thing as a free lunch. The benefit of borrowing cheaply in Euros comes at a considerable cost. Because the stronger European economies are, in effect, underwriting the debts of the weaker, the European Central Bank (ECB) must impose limits on the amounts that each country can borrow, and these limits are calculated as a percentage of the country’s GDP (Gross Domestic Product), rather like a bank which will limit its loans to a percentage of a company’s or individual’s income or net worth. Even before the pandemic had decimated their economies, Italy, France and Spain were already struggling to stay within the 2.5% ECB borrowing limit, but to avoid individual countries having to wrestle with the economic fallout from the virus, the ECB has coordinated a giant rescue package of funding that, in effect, is to be underwritten by the stronger Eurozone economies. The distribution of this package is likely to have a strong redistributive agenda with a high proportion of the funding raised being distributed to East European members. So far so good – surely such a coordinated and collegiate approach is the core justification for the European Union?
The risk to approval for the recovery funding relates to whether this gigantic central support package is delivered in the form of loans or gifts. The original proposal was for some and some. The Scandinavians and the Dutch do not believe that gifts of their taxpayer’s money to profligate Italians and Greeks would pass muster with their electorates who might find contributions in the form of loans more palatable. In contrast Germany and France are enthusiastic supporters. The latter because President Macron makes no secret of his ambition for a move the Eurozone towards a United States of Europe, Germany because their economy is the prime beneficiary of a low currency valuation that enables it to generate massive trade surpluses, enriching Germans and impoverishing weaker Eurozone trading partners such as Italy.
A collapse of the Euro and a strong German currency would have a serious negative effect on Germany’s terms of trade. The more likely scenario is for Italy and perhaps others to leave the Euro and benefit from more competitive domestic currencies. By pushing the Euro to a higher valuation, German goods and services would be less affordable to trading partners with weaker domestic currencies. Of course, this is exactly what Eurozone members with big deficits need – a weaker currency would make their goods and services cheaper for German and other Eurozone consumers to buy and their economies would become more competitive.
For the Euro currency to survive and prosper in its current form, the Eurozone must move towards a single central bank, a single central issuer of debt and uniform taxation rates – a United States of Europe in all but name. If they pull off the rescue package and economic convergence and regional support becomes the Eurozone’s inevitable direction of travel, the common currency will survive. If not, it spells the end of the Euro in its current form. The currency’s recent strength seems to suggest the market’s confidence that the package will be approved, but a cynic might conclude that Dollar weakness has been more due to a rampaging virus in the Americas and the economic consequences of the incumbent US President’s irresponsible economic strategy for re-election. On balance the odds are that the rescue package will be approved – there seems little alternative. But whether 750 billion Euros sorts the problem is another matter altogether.
