The Background
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 pro-Euro supporters.
The major flaw here, as accepted by many respected commentators, is that this ideology ignores the fact that each individual country across Europe has different desired outcomes.
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, MEPs in Brussels continue to struggle to get buy-in to their rules and regulations.
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. What crisis, I hear Angela Merkel say?
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 global 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 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 have all seen changes in governments. The French have an election next year and the Germans are governed by a coalition. Hardly a ringing endorsement!
The Potential Solutions
Most are clamouring for the European Central Bank (ECB) to step in and act as the lender of last resort to the distressed nations. This would have the effect of reducing their borrowing costs, but not necessarily their profligacy. In fact it might even encourage it!
Germany remains staunchly against this, as it would in effect be the ECB printing money which, as we know, is likely to be inflationary.
The next option, currently under consideration, is the introduction of Eurobonds. These would in effect be underwritten by the stronger countries (Germany) and benefit the weaker countries by enabling a lower borrowing rate. However, the stronger countries would demand a say in the running of the smaller countries to make sure they stuck with their austerity plans. The weaker nations of course won’t like this – back to the flaw in the concept. This option is for the longer term and will not solve the current crisis.
The other options are for a break-up, or partial break-up of the eurozone. Very unpalatable to all.
It seems the likelihood is that Germany will continue ‘kicking the can down the road’ for as long as they can, saying all the time that they will definitely not support ECB intervention. However, ultimately, to save the euro in whatever form they can, it is likely they will have to accede to this. The alternative, a breakup of the eurozone, would not be good for them. 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!
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 lose their money. They took a risk to invest on the basis that it might be the next Microsoft or Apple.
We are now getting to the big guns with Italy and France. This is exactly the same as the sub-prime crisis. Suddenly the casualties are too big to fail. If the Europeans adopt the same strategy as with the previous crisis, these countries will be bailed out to avoid such a potentially catastrophic collapse. Germany, and the European Central Bank, will be forced to become the lenders of last resort, as the alternative forEuropewill be disaster.
Whilst many will argue that this will be preferable to an outright failure, in my opinion it would result in many more unintended consequences for years to come.
John Thompson is a consultant for Bibby Financial Services
