‘If the Euro falls, Europe falls.’ These were the words of German Chancellor Angela Merkel in 2011. It is telling of the scale of the longstanding issues faced by the EU that words spoken seven years ago remain so relevant today. The next economic crisis will be existential for the Euro.
After all, it barely survived the last one and if the next comes anytime soon it will be far worse for Eurozone countries. All around Europe, interest rates are ultra-low, and quantitative easing (QE) drags on. Indeed, as poor economic news was released last week it became evident that quantitative tightening remains a while off. Public debt levels are sky high in the Eurozone, leaving it vulnerable to a recession. Further still, political fatigue and unemployment are at higher levels than 2008. The Delors Report in 2016 concluded the Euro will not survive the next crisis in its current state, and I find it difficult not to concur.
One of the crucial issues is the question of how the European Central Bank (ECB) could react to this crisis. The implementation of the asset purchase programme (the ECB’s name for QE) has resulted in it coming very close to its limits on purchases of government bonds from member states. These limits were established to protect the integrity of the Eurozone by preventing the ECB from funding state budgets. Effectively, in the event of another crisis, the central bank would have limited scope to buy more bonds. Interest rates are already at incredibly low levels, making cuts to them unviable. In order to create more room for manoeuvre the ECB would have to unwind current QE and bring interest rates back up.
However, with inflation failing to pick up and growth data weak, tighter monetary policy does not seem on the cards. In the current climate, any rapid end to policies of QE and low rates is likely to cause mass instability in financial markets. Such instability would cripple the economy. This issue comes from asset bubbles created by QE and ultra-cheap money. Expensive bonds mean low bond yields. This is perhaps best demonstrated looking at junk corporate bonds. ECB asset purchases have resulted in yields of junk debt like these bonds reaching levels as low as 2%. These bonds are called junk for a reason – they have high default risks. Yet yields do not compensate for this. Investors will lose out if debt ceases to be so cheap and zombie firms issuing junk bonds go under. These investors include pension funds and other key components of the financial system who’ve had no choice but to buy risky debt to make viable returns.
Rapid tightening of monetary policy, then, is not an option. So if it does not drop its limits on bond purchases, which would undermine the integrity of the monetary union, the ECB could be left with almost no scope to implement monetary policy the next time a crisis comes around. In a world where monetary policy has long been the default response to such scenarios, this situation would be catastrophic. The ECB can only sit and hope that economic data improves fast, but it shows little signs of doing so.
It’s clear that a crisis in the near future would quickly become a catastrophe for the Euro, but the problems within the Eurozone are not limited to this. Fundamentally, the root of these is the existence of monetary union without fiscal union. Such a system has created a myriad of issues. The lack of ability to revalue currencies to maintain competitiveness alongside a divergence in supply costs between countries has created a concerning scenario. Several Eurozone countries have become hugely uncompetitive against Germany. Labour costs are the most prominent driving force here. If wages rise more in one country than others, the country with higher wage growth will lose competitiveness. With inflation at such low levels, there is little chance of wages elsewhere catching up quickly. With a single currency, this competitiveness cannot be restored by currency movements.
Deficits are another huge issue within the Eurozone. Under the Stability and Growth Pact, ‘excessive deficit’ spending (in excess of 3% of GDP) is not meant to be allowed. Greece ran deficits above 10% of GDP for 5 years between 2008 and 2014. The EU has forced unprecedented levels of austerity on the Greek economy, without which defaults on debt and exiting the Euro would’ve been the outcome. Austerity may have succeeded in bringing the budget into surplus, but Greek GDP per capita was 24% lower in 2016 vs pre-crisis levels. France and Spain continued to run deficits in excess of the SGP’s limit in 2016. For all intents and purposes, the pact isn’t working. Northern countries cannot carry the South forever and with current levels of debt, many Eurozone countries are incredibly vulnerable to a global downturn.
The no-bailouts clause of the Maastricht Treaty has also, of course, been violated repeatedly particularly in the case of Greece. This has compromised the system in the view of Professor Otmar Issing. Prof Issing is considered the father of the Euro and was the ECB’s first Chief Economist. He believes the European Commission is facing an ‘overwhelming’ level of moral hazard, having given up on trying to enforce the original rules in a desperate attempt to prop up a failing system. It is difficult to walk away from this argument with any view other than that the Eurozone will simply not last. Prof Issing says ‘the house of cards will collapse.’
As long as the ECB does not raise rates or implement quantitative tightening – and it cannot do so quickly, as such actions now would themselves cause a collapse of the single currency, the question of how long it will stand becomes one of how long there is until a crisis manifests itself. Predicting exact timing of crises is never easy. However the history of the economic cycle tells us that with the last crisis having been a decade ago, the next may not be far away. If fiscal union – a political near-impossibility – or other sweeping reforms are not achieved, expect it to bring about the collapse of the Euro. Perhaps it will take the European Union with it.