‘If membership of the Eurozone had been confined to the original ‘Deutschemark Block’ – Germany, France, Holland, Belgium and Luxembourg which met the Euro’s initial convergence criteria – the Euro could have been a success. However other countries that did not meet the entry criteria but were nevertheless welcomed into the currency. Recent problems have demonstrated that the weaker applicants should have been made to wait until the Eurozone’s convergence criteria were achieved before replacing their domestic currencies with the Euro, but as is so often the case, politics trumped economics and these members are now living with the consequences. Uncompetitive exchange rates, continued austerity, high unemployment and falling wages among the weaker economies have exposed the Eurozone to the risk of political turmoil as disgruntled voters turn to parties that promise to end austerity and fiscal discipline. Herein lies the threat to the Euro.’
Pricing is a function of supply and demand. The greater the demand and the lower the supply, the higher the price. This truism also applies to money. If the supply of money is limited, then its value can be underpinned. If the supply of money is infinite, then it requires a trick of confidence if its users are to trust its value. The Euro shows many signs of danger but given the strength of its backers the currency will survive. However, its continued use by economically weak, impoverished and indebted nations will inevitably lead to further protests and protest votes in countries where voters are fed up with high unemployment and falling living standards. This has already brought about the election of politicians that promise to disrupt the political status quo and end the austerity imposed upon them by the Euro. For the Euro to survive in its current form, its members will be forced to sign up to a United States of Europe – with not only a single currency but uniform taxation and centralised borrowing.
The inept introduction of the Euro has already caused distress to several Eurozone economies. Problems with currencies that have no intrinsic value are not exclusive to the Euro, but the Eurozone’s obvious internal economic inequalities provide cause to fear that the European currency’s days as an effective means of exchange and store of value could be numbered. The notes and currency that are today generally accepted as payment in exchange for goods and services are merely ‘Promises to Pay’ and for as long as users of the currency believe that a central bank’s promise is credible and that the borrowing country is therefore creditworthy, currencies are accepted in exchange for goods and services. But herein lies therub.
Since the French Revolution there have been many occasions when a nation’s currency has had confidence in its value so drastically undermined as to be rendered worthless. These have not been confined to corrupt third world economies but include France and Germany, and there have been two occasions since the mid 1970’s when the UK’s currency and banking system have come perilously close to a collapse in confidence, namely during the 1974 secondary banking crisis, and the queues of depositors outside Northern Rock’s branches following the Financial Crisis in 2008 also demonstrated a fear of insolvency. And we should not forget how close the Greek debt crisis came to undermining the Euro in 2009. A currency backed by an asset with a finite supply such as gold or even Bitcoin, cannot be easily debased through oversupply. An IOU is different because borrowers can and often do fail to honour their debts and with Greece, the absence of support from the European Central Bank (‘ECB’) would have already bankrupted the country and forced it out of theEuro.
Over the past decade, central banks in the US, Eurozone and the UK have issued vast quantities of IOU’s to refinance their dangerously indebted and under-capitalised banking systems. The combination of Quantitative Easing (‘QE’)* and very low interest rates was intended to facilitate lending and provide a sugar-rush to kick start the Eurozone economies and, as a result, Europe has enjoyed a period of economic growth. However, while the strength of the recoveries in the US and UK have allowed QE to be dramatically reduced – and in the case of the US, stopped and reversed – the Eurozone’s less robust recovery has not.
*QE is a policy whereby a central bank buys predetermined amounts of bonds or other financial assets in order to inject money directly into the economy.
A strong economy has allowed the US to push Dollar interest rates back up towards more normal levels without choking off growth. This means that when there are signs of another slowdown, the Federal Reserve can and will decrease interest rates to protect the banks from bad loans and help to boost their economy. Thanks to Brexit uncertainty the UK has managed just one rather paltry interest rate increase from 0.5% to 0.75%, but there is at least some scope to decrease rates if necessary, and the continued growth in the UK’s dominant service sectors suggest that if and when the Brexit uncertainty is removed, the next move in interest rates could still be upwards.
By way of contrast, consider the Euro where, despite an economic recovery of sorts, interest rates remain belowzero – it costs a depositor 0.4% per annum to leave his or her Euros in the bank. As we approach the next recession, the European Central Bank (ECB) is therefore unable to provide any meaningful stimulus by reducing interest rates and will be forced to continue to print yet more Euros through QE to stave off deflation anddepression.
The Euro was a fundamentally good idea. The certainty that it provides for businesses trading with neighbours using the same currency and the absence of the cost of exchanging currencies, fully justified the currency’s introduction. But unless their economies converge, users of the same currency cannot for any length of time maintain separate and different economic policies and cycles. Imagine if Scotland and England maintained wholly independent economic policies and debt management rather than one implemented by a common central bank and treasury.
The Eurozone allows just that. Within certain EU constraints, Eurozone countries can have different tax regimes, but they cannot cut interest rates or de-value their currencies to stimulate their economies and make them more competitive.
One size fits all, whether you are Germany or Greece, and this is a fundamental weakness. Eurozone rules prevent countries from borrowing more than 2.5% of their Gross Domestic Product (GDP). Italy and France both borrow a higher percentage and are therefore breaking the rules and must decrease spending and/or increase taxation.
Otherwise they will be fined by the EU. Italians have decided that their belts have been too tight for too long and raised two fingers to Brussels, electing a coalition of populist parties from the right and the left whose common promise is to increase borrowing and spending above the EU limits to bring down unemployment and raise living standards.
In common with Eurozone countries, the UK is also made up of regions that display different levels of economic performance, employment, living standards and life expectancy, so how does this work with only one currency and a single interest rate for every region? These imbalances are managed through regional policies – tax raised from the more affluent areas of the UK is spent and invested in more deprivedregions.
Through the European Budget negotiations to a limited extent this redistribution also happens within the EU. The UK and Germany are the two largest net contributors to the EU budget, but these redistribution policies are primarily focused on infrastructure spending where the effects can take many years to benefit a country’s economic performance, productivity and competitiveness. Shorter term stimulae such as tax cuts and government spending designed to increase activity and employment are financed through domestic tax and borrowing at the individual country level. But when Italy announced its intension to borrow and spend the country’s way out of low growth, high unemployment and falling incomes, the country was set on a collision course with Brussels.
So, the Euro wasa good idea, ifits members were prepared and able to coordinate their economic policies and minimise the weaker member’s requirement for support or very high borrowing. It’s one thing UK tax payers accepting that less affluent regions within their own borders need help, quite another to convince German taxpayers to continue funding profligate Greeks or British taxpayers to fund Portuguese motorways while dodging potholes at home.
Confidence in the value of money is not exclusively a Eurozone problem. US and Chinese government debt issuance has also spiralled out of control in a bid to stimulate the global economy and stave off deflation and depression post the 2008 crisis. However, unlike the Dollar and to a lesser extent Sterling, the Eurozone has fired all of its bullets and lacks the ammunition that they will require to stave off or mitigate the effects of the impending economic slowdown. Voters have had enough of austerity and populist parties of both the left and right are gaining support on the back of promises to turn inwards, to borrow to spend, to end austerity and to raise living standards.
Another financial crisis will finish off several of the weaker European banks, but if we wish to credit the Eurozone with one major advantage it is that, up until now, the stronger banks and countries havesupported the weak in times of crisis. Greece and Cyprus have proved just small enough for such support to be manageable, but there is no way that the Eurozone can cope with the rescue of a Eurozone economy and banking system the size of Italy’s. An insolvent banking system will not be confined to Italy – there will be serious contagion from other Eurozone banks’ exposures to defaulting the Italian banks.
The best and possibly only way to avoid the Euro’s implosion will be for the new team in Brussels to acknowledge that there are two EU’s – one in, and one outside the Euro which, as with the UK, can depreciate its currency and set its own interest rates. Countries inside the Eurozone now require centralised and coordinated economic management and debt finance. If this leads to the reforms that reflect this reality, the Euro just might become habitable. If not, then more drastic measures will be forced upon the Eurozone as the weaker countries are pushed out and back into their domestic currencies. This will be a neither seamless nor painless transition and will leave dangerous levels of debt defaults in its wake. The added cost of servicing Euro debts with a depreciating Lira will not be manageable.
Recent signs of a global economic slowdown may not translate into a full blown global recession, but the political and trade protection stars are aligning to that eventual outcome. Not only is it likely that the Eurozone will remain towards the bottom of the global growth league, but it is also not in a strong position to mitigate the next slowdown. Although possible, it is hard to see how, after already one decade of high unemployment and falling living standards, the weaker Eurozone members’ voting public will continue to tolerate fiscal and monetary austerity for the next. An important by-product of Brexit will be the UK’s distance from what will be an expensive and painfultransition.
