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What lies in store for the euro?
The euro area has made reasonable economic progress in recent years. It has been recovering from the Western banking crash and credit crunch of 2007-9 and from the euro crises of 2011-13. A general calm has descended thanks to Germany and the other surplus countries depositing their money at the European Central Bank (ECB), which can then lend it on to the deficit countries and stretched banking systems of the south and west. Our central forecast assumes the euro will continue to muddle through.
It is necessary to examine the risks from time to time, as the euro is not like a national single currency. The dollar or the pound are backed by a single central bank that controls the resident banks in that country, and are backed by the taxpayers of America or the UK as we saw in the crash. The central banks are arms of the state, and the two work together. The euro is a bit different, with no single national group of taxpayers behind it. National governments continue to have some role in regulating and supporting commercial banks, as well as the ECB.
The euro had a strange birth
France was worried by the reunification of Germany and the rough symmetry of French and German power as the two dominant influences in the EU was disrupted. With the extra people and territory of East Germany joining the West, Germany gained more influence from having a larger population in the Council of Ministers, more seats in the European Parliament, and became clearly a much larger economy. France decided that it needed to bind Germany into their shared institutions of the EU more firmly by proposing rapid moves to a single currency, which would force more co-operative decision taking and budget sharing.
Germany agreed with heavy qualifications. Germany decided that the euro had to be based on strong financial disciplines. It ruled out the usual transfer union, where rich parts of a currency zone pay more tax and send more money to the poorer parts. The German theory was that the poorer member states could, by their own exertions, get up to German levels of income and efficiency. They could, after all, benefit from the common lower interest rates and the common acceptance of a larger mainstream currency. Each member state would remain responsible for curbing its own state deficit, for reducing excessive state debts, and running a tough economic policy to curb inflation.
To reinforce the agreement, the EU signed up to German-style disciplines for any country seeking to join the euro. A state had to have a debt level below 60% of its annual GDP, and had to promise to keep its annual budget deficit to below 3% of GDP. There were also requirements on inflation and currency fluctuation prior to joining. When it came time to decide which states would join the new currency in 1999 there was an immediate problem. Most of the states had borrowed too much already and did not qualify. Ironically, this included Germany, where the merger with East Germany led to higher levels of state debt. As a result, the criteria were suspended and all were allowed to join who wanted to. This included Greece, with massive state debts, and with some creative accounting to put the figures in the best light. It later included Cyprus with quite high levels of state debt and large and weak banks. The stage was set for the subsequent euro crises, when the ECB did not stand fully behind the banking systems of Greece and Cyprus. They forced tougher adjustments to be made entailing stops on euro payments or reductions in values of euro deposits as part of the solution to their debt crises.
Debt a concern
Today, little progress has been made in reducing the state debt levels, despite the continued requirement to get state debt down to below 60% of GDP. A majority of euro states have substantially higher debt levels, including all the large economies. Italy has state debt at 132% of GDP, Spain 98%, France 97% and Germany 64% (end 2017 EU figures). Greece at 178% remains the most exposed, with Portugal at 125%, Belgium at 103% and Cyprus at 97% also high. The euro area as a whole has a debt ratio of 87% of GDP against the 60% target. This does still matter. The reason Germany wanted controls was to avoid free riders, where an ill-disciplined member state could borrow a lot more than desirable taking advantage of the lower rates of the zone as a whole. Uncertainty over whether and to what extent the ECB and the zone will stand behind non-compliant states means individual countries do often have to pay considerably more than the average to borrow. It also means there can be occasions, as with Greece, where there is an individual state debt crisis, with markets unwilling to lend in the absence of wider zone guarantees.
There are also problems where a state sponsors too many weak banks. The ECB has now strengthened its supervision and controls over commercial banks throughout the zone, but often requires national authorities to take an interest in forcing reconstruction or refinancing of weak banks. The Cyprus crisis was primarily about overextended banks. The Irish crisis was also heavily influenced by a small country being host to large and weak commercial banks.
So what could go wrong from here? There could be struggles with countries that dislike the financial disciplines to the point of raising doubts about their continued membership of the single currency. We see in Italy the election to office of two challenger parties that have both in the past advocated leaving the euro, or advocated staying in on terms that are unlikely to be negotiable. The new government has said it wishes to stay in the euro, but it also wishes to set a non-compliant budget at a time when Italy still has very high outstanding levels of state debt. The countries to the east of the EU are also in a mood to challenge features of EU government.
Reform agenda
There could also be increasing pressure on Germany from core members to make changes. Mr Macron will seek to lead these pro-euro reform moves. He wishes to have a more integrated euro budget, with implied larger transfer payments from rich to poor. This will require the consent of German politicians and electors, something which has not been forthcoming throughout the euro’s history so far. German consent for the euro rests on its German model, where there is no formal recourse to German taxpayer funds to meet the budget needs of poorer states, and rests on the assumption that there will be no free riders in the debt markets. This sets the euro up for reruns of the Greek and Cypriot crises if states are unable to live with the disciplines imposed.
It is this unusual architecture, designed to protect German taxpayers, that leads to worries in markets. Our base case of muddling through assumes Italy will accept enough of the disciplines of the zone to avoid the challenge becoming a crisis. It assumes the reformers will not press Germany beyond what can be sold to German electors. Populist parties of the right and left are doing well in elections around the zone, as voters display fatigue with the austerity policies the euro requires. The euro authorities are rather like the IMF dealing with problem countries, insisting in a case like Greece that they put taxes up and cut spending. All euro countries have to accept budget review and advice from the EU, and face fines and penalties if they do not comply with requirements to cut deficits.
This is why investors need to keep an eye out for the evolution of these arguments. There is a truce today based on give and take and based on the ability of the ECB to keep money flowing around the zone. If any member state pushes too far against the scheme, we could go back to turbulent and worried markets as we saw in 2011 and 2013.
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