The Euro: an unfinished project and why that is important now

This piece is much longer than our normal blogs. 
We hope that you find it of interest of course, however the somewhat technical language and length is makes this quite different to our normal publications.

To many Kiwis, the Euro is simply the currency of Europe. Just as the New Zealand Dollar is the currency of New Zealand. There is no fundamental difference. However, this is not the case.
The Euro is very much an unfinished project that is held together more by political will than economic norms.
Its very structure and system of operating has not only impeded the performance of most member economies, it has already threatened to plunge the European economy as a whole into destructive chaos.
With inflation now rising around the world, it could be about to do so again.

 

The history of the Euro

The Euro was launched on the 1^st of January 1999.

With the introduction of coins and bank notes on the 1^st of January 2002, a host of currencies ceased to exist. The German Deutschmark, the French Franc, the Dutch Guilder and the Italian Lira among them.

In all there are now twelve member countries of what is termed the Eurozone. 

The purpose was to aid European business, by removing exchange rate risk, and hasten closer European integration between member states.

For the European Union, its introduction was the culmination of decades of work. The attempts to introduce it had often been frustrated by national Governments’ self-interest. Eventually it was a concerted effort spearheaded by Jacques Delors, who served as President of the European Commission from 1985 to 1995, that led to its formation. 

Delors knew that for the currency to work the economies of the member states must become more similar. In economic parlance, there must be “convergence criteria” agreed to and met.

The rules of membership stated that: 

1. Inflation at a rate no more than 1.5 percentage points higher than the average of the three best performing (lowest inflation) Member States;

2. a "budgetary position" that avoids "excessive" government deficits defined in ratios to gross domestic product (GDP) of greater than 3% for annual deficits and 60% for gross government debt;

3. the exchange rate of the national currency within "the normal fluctuation margins by the exchange-rate mechanism of the European Monetary System without severe tensions for at least the last two years"; and

4. nominal long-term interest rates no more than 2 percentage points higher than in the three Member States with the lowest inflation[1].

 

For economies as different as the prudent Germans, the credit-hungry Italians and the Greeks who largely view taxation as optional, these proved extremely difficult goals to meet.

A very perceptive article from the Wall Street Journal in 1996 foresaw what came to pass:

 

“ Traders now seem to understand that (Monetary Union) is a matter of political will, not economic credibility…. And so it is that the debate these days is not about whether or not it will happen, but about how those notorious convergence criteria are going to be fudged to make it possible.”

 

The British Pound was forced out of the Exchange Rate Mechanism on the 16^th of September 1992, never to return. The Italian Lira was forced to devalue from its original entry point. The crisis was only resolved by expanding the permitted fluctuations from 2.5% to fifteen percent (except for Germany and the Netherlands which retained the original band).

The political will was now sufficient to ignore all these economic realities and press ahead with the Euros introduction. As even Delors himself commented in 2011: “the eurozone was flawed from the start and that efforts to tackle its problems have been ‘too little, too late’"[2].

Delors was speaking in the aftermath of the first major test which the Euro had faced: the Global Financial Crisis (GFC).

The GFC led to the Eurozone Sovereign Debt Crisis. As Will Kenton explains: 

“The debt crisis began in 2008 with the collapse of Iceland's banking system, then spread primarily to Portugal, Italy, Ireland, Greece, and Spain in 2009, leading to the popularization of a somewhat offensive moniker (PIIGS). It led to a loss of confidence in European businesses and economies. The crisis was eventually controlled by the financial guarantees of European countries, who feared the collapse of the euro”

 As the US Congress report into the crisis summarised: 

“The Eurozone debt crisis began in late 2009 when a new Greek government revealed that previous governments had been misreporting government budget data. Higher than expected deficit levels eroded investor confidence causing bond spreads to rise to unsustainable levels. Fears quickly spread that the fiscal positions and debt levels of a number of Eurozone countries were unsustainable.” 

Greece almost exited the Euro. The cost of staying in was more brutal than the Great Depression of 1930’s America. 

Essentially the fudging of the figures at the Euro’s birth had been dramatically exposed by the laws of economics. The Euro was ultimately saved through the imposition of tough austerity measures and the incredible impact of a speech by the European Central Bank chief, Mario Draghi, who pledged to do “Whatever it takes” – which led to his nickname: Super Mario.

  

 

The situation today

Despite this turbulence and the misery of the austerity, little has changed. The fudges have just become larger and more complex.

Aside from reduced transaction costs for businesses and consumers, there have been few obvious benefits for most people in the Eurozone.

For example, the Italy’s economy did not grow at all from the establishment of the Euro until the onset of COVID. Twenty years of no economic growth is unprecedented in a modern first world economy.

By comparison the UK economy grew by over 43% in that time. There is of course debate as to how much the Euro was a factor in these two figures (the UK not being a member), but it is hard to argue that the Euro has helped Italy.

 

The primary winner appears to have been Germany.

The Euro has made Germany’s exports more competitive than the Deutsche Mark ever could have.

The austerity inflicted on Greece (described earlier) ensured that Germany’s banks wouldn’t face the consequences of their reckless lending practices.

As the largest constituent of the Euro and the richest country in Europe, Germany has enjoyed the role of the leader of the EU for decades now.

 

While the Euro has seen it’s exports boom, Germany has failed to import from other countries. There are of course numerous reasons for this lack of demand but the result is an imbalance that has been described as “a time-bomb for the Euro” 

However things may be about to change.

 

 

Why does this matter to you?

If there is one thing that Germany fears it is inflation. Since the desolation wrought during the interwar years with Hyperinflation, the Government has sought price stability above all else.

For most of the past twenty years, Europe’s greater problem has been the threat of deflation. As experienced by Japan since the early 1990's continually falling prices is actually a much trickier problem to solve.

This has worked well for the majority of the Eurozone’s other (less healthy) members, as the Quantitative Easing (QE) and negative interest rate measures employed by the European Central Bank have papered over the cracks in the system that have persisted since the debt crisis ten years ago. 

QE and negative interest rates are seen by the ECB as the best way to avoid deflation. It also allows insolvency (at both corporate and sovereign level) to go unnoticed as trillions of euros are created and pumped into the system. 

However now things are changing. Suddenly inflation is back. The official inflation rate in Germany has jumped to 5.1%[3]. Energy prices have risen by over twenty two percent. 

It is hard to justify negative interest rates and on-going QE when inflation is so high.

But what about the countries and companies that depended on it?

How will the “Club Med” countries cope with the money-tap turned off? As the legendary investor, Warren Buffet, said “Only when the tide goes out do you discover who's been swimming naked.”

 

It is entirely normal for there to be richer and poorer areas within a currency block. Essentially the richer area subsidises the poorer one through distribution of tax revenues. London subsidises the North of England. New York subsidises New Jersey. Auckland subsidises Northland, and so on.

This redistribution of taxes is termed “fiscal transfers”.

The problem is that these do not exist in the Eurozone. Germany and Holland have resisted paying money to the poorer Southern members. 

Instead of funding them, a complex system of loans has been arranged between countries and their banks. The largest system, Target 2, involves truly eye-watering sums of money. By October 2020, Germany was “owed” over €1.15 Trillion[4]. 

The Eurozone banks are essentially bust.

The market has realised the amount of debt that they hold to “Zombie companies”, (that would have gone bankrupt but for QE) is unsustainable.

As of October 2020, the likes of Société General (France’s 3^rd largest bank) had a “Price to Book” ratio of 16%, Deutsche Bank’s (Germany’s largest bank) was 27%. As the team from Goldmoney Inc put it in their assessment: 

“When markets place a price to book valuation of considerably less than 100% on any enterprise, they tell us the enterprise is not just insolvent, but in a winding-up, shareholders are unlikely to recover their funds. So, when we observe that Société Generale, the major French bank, has a price to book ratio of only 16.4%, without a major capital injection it is almost certainly bankrupt because its share price is little more than option money on its future survival”

With inflation rampant the pressure from Germany for the ECB to cease QE and raise interest rates, will be enormous. The poorer members and their banking systems appear extremely vulnerable to such moves.

 

It is unclear, of course, how this will play out.

However the contradictions at the heart of the Euro project appear to spell danger for the markets once more.

Some are predicting that the Euro will implode.

Personally I thought that that would happen ten years ago. At that time political will to see the project survive was greater than I’d realised. Arguably it was greater than the will to protect the people of the Eurozone, who endured huge hardship in the process of saving the currency.

It is likely that the political will is as strong as ever.

The question now is: will the markets believe the ECB is once again strong enough to save the currency a second time? Will saying "whatever it takes" work a second time?

If not, the implications for the world economy are grave indeed.

 

Anyone concerned about the potential implications for their portfolio is encouraged to get in touch for a review.

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[1] Source: https://en.wikipedia.org/wiki/Maastricht_Treaty

[2] Source: https://www.theguardian.com/business/2011/dec/03/eurozone-flawed-start-jacques-delors

[3] Source: https://www.destatis.de/EN/Themes/Economy/Prices/Consumer-Price-Index/_node.html

[4] Source: https://seekingalpha.com/article/4381222-destruction-of-euro

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Disclaimer: This communication is purely meant as information for general interest. It is in no way to be taken as financial advice or relied upon in any way for investment decisions.