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Euro Ultimately Headed for Failure as Deep Fractures Remain Intact

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The great European project, the attempt to fuse the nations of Europe into a single political and economic entity, is unravelling according to analysis from Macquarie Research.

And according researchers at the Australian bank, the Euro and its geographical units that form the Eurozone, will ultimately fracture along familiar lines.

Victor Shvets and Chetan Seth, authors of a Macquarie Research report into the future of the European Union and Eurozone, argue that European fault lines which the Union seeks to cover are starting to reappear thanks to the great financial crisis (GFC). 

The crisis crystalised and laid bare the hidden fault-lines that separated the different cultures and geographies of Europe: north / south, protestant / catholic, Europe ‘proper’ / the hinterland. The analysts draw on the works of Samuel P. Huntington who in 1992 noted that whilst Istanbul, Tbilisi and Sofia are all geographically in Europe, where would one place its eastern frontier?

The answer to Huntington was that the edge of what is recognized as Europe runs along the ancient Holy Roman and Habsburg Empire frontiers. In other words, it separates Catholic and Protestant areas from the Orthodox and Muslim regions beyond.

"Why is this important? In our view, it not only explains current conflicts in Ukraine or Crimea but also why EU is experiencing difficulties integrating states like Bulgaria or Romania. It also explains why Germany had been reluctant to bail out Greece, Italy or Spain," argue Seth and Shvets.

The authors argue that given another 100 years – 50 even – and the EU may have blossomed into the nation-state envisioned by its pioneers.

"After all, a sizable proportion of younger citizens already identify themselves as Europeans first, and if given another two or three generations of ‘Erasmus scholarships’, the revival of Latin as a common language as well as growing benefits of labour mobility, Western Europe (ex Britain perhaps) could have evolved into a much tighter and coherent entity," say the analysts.

The authors argue even some of the areas in Central and Eastern Europe could have made the transition.

“After all, it took France roughly five hundred years to create what we call France today, from a variety of quite disparate peoples and languages, and hence, one probably needed at least another fifty to one hundred years. However, it was not to be, and the Global Financial Crisis effectively stopped the project dead in its tracks," say Seth and Shvets.

The big question then is does this process of fracture continue, or will steps be taken to meld the cracks?

North and South Crack

For the EU the greatest crack to open up was between the core and the periphery, and the project has any hope of surviving it must be in the bridging of that divide.

The rhetoric of division which characterised the financial crisis in Europe exposed the deep differences between the societal and cultural norms between the two halves.

Shvets and Seth suggest the simplistic rather prejudiced views dominating the debate, with the south characterised as lazy, extravagant, corrupt, and unproductive, and the north or core as hardworking, thrifty, competitive and straight, obscure a more complicated picture.

The first point is that the introduction of the Euro meant that investors treated the whole of Europe – from a creditworthiness perspective - like a greater Germany, and this led to much lower borrowing rates than had traditionally been accessible to citizens in the periphery, where inflation rates had, on average been 8% prior to 1995.

The availability of cheap sources of lending led to a borrowing spree in the periphery which had unheard of in terms of scale and proportion before.

An unadulterated optimism which led to the subprime crisis in the US fuelled the drive for credit and – in Spain and Ireland, for example –  this led to saturation with the overdevelopment of the property sector.

However, this set up the grand fall which occurred during the great financial crisis (GFT) and we are in a scenario today where we hear the German finance minister openly advocates for Greece's exit from the Eurozone.

An Economic Ecosystem

But there are other factors too according to Shvets and Seth, including an interdependence of the economies of Europe which make the fallout from the crisis a more shared responsibility than the core might want to accept.

The course taken by the Germany economy, for example, which had its roots in reunification, impacted on the other countries in the EU, they argue:

“Whilst there are some real cultural differences and unwillingness to accept certain policies, one cannot judge one country against another, without recognizing that policy decisions tend to be interactive.In other words, decisions by one country force another country to adjust.

“For example, undervaluation of DM going into Euro in 1998/99 as well as a state coordinated policy to restore productivity (following re-integration of East Germany), have created today’s German export and savings machine which, in turn, forced countries as diverse as Greece, Italy or Spain to adjust."

The point raises a familiar criticism of the Germans, which is that they are quite happy to export to the rest of Europe but when it comes to spending their surplus they are overly tight-fisted, thus depriving other countries of the export market they so assiduously exploit for their own benefit.

Blood Runs..

Deeply embedded cultural norms which govern behaviour and relationships survive in people for centuries, argue the authors, and these exacerbated the fractures in the attempts to unify Europe:

“The last three decades of Greek history and indeed more than a century of differentiated history for North vs South Italy seem to suggest that it is not just resources or introduction of formal rules that is the key but rather deeply embedded cultural and social practices.

“These institutional and cultural frameworks determine how businesses, people, and bureaucracies behave, irrespective of formal rules. As Douglass North highlighted, it is easy to change formal constraints on human behaviour (such as introducing new Constitutions) but it is far harder to change much more powerful ‘informal constraints’.

“These informal norms tend to survive the most violent of upheavals (including revolutions). All one needs to do is to witness how the key role of family ties (something that every Chinese Emperor had to fight against) reasserted itself following the Deng Xiaoping era in China; or how Greek society condones extensive graft and tax avoidance or the persistent role of the Mafia in Southern Italy."

The Mistrusting South

One of the issues which has exacerbated the financial crisis in the South has been the difficulty with which governments have tried to source revenue, but this is as a result of centuries inbred cultural differences, say Macquarie.

Where as in Northern Europe individuals by and large trust the state, in the periphery they hold state officials in mistrust, suspecting wrongdoing and corruption, and it is due to this, that, problems have arisen, for example, in relation to the recovery of taxes.

Shvets and Seth argue:

“Given historical lack of impartial and consistent institutions that were able to deliver relatively efficient and impersonal services, Greek tax payers have never seen a point in paying taxes and tended to only trust immediate neighbours or close associates.

“Given that the state over an extended period (centuries) could not deliver basic public services or keep law/order and that whether it was the Ukraine, Serbia, Greece or South Italy, foreigners had ultimate control, the process of creating and strengthening local institutions had never occurred.

“Hence, lack of trust and the persistence of the Mafia and other patrimonial/patronage practices as delivery vessels for otherwise missing public services."

The Old and the New

One of the problems with the single currency from the perspective of peripheral economies was that it removed an important escape valve for the nations of Europe to regulate their economies – that is via the devaluation of their own currency.

In the past if a country in the periphery ran into economic trouble it would simply devalue its currency to increase competitiveness, and whilst this worked fairly well at maintaining a kind of stability, it did not address the fundamental, underlying problems which had caused the economic ineffectiveness in the first place.

“Essentially, the ability to devalue local currencies allowed nations with lower-than-average productivity to regularly boost their performance through periodic devaluations, rather than addressing deeper structural issues facing their economies, such as social norms, institutions, labour market regulations or restrictive professional and trade rules,” remark the Macquarie analysts.

Without the lever of their own currencies it laid bare the economies of the periphery to deeper scrutiny, which it remains to be seen how effective it is.

In Spain, there seems to have been a greater willingness to reform outdated, inhibiting practices and norms, where as in other countries, notably Italy there has been more resistance to reform. 

Partly as a result the crisis this resistance has deepened, such that from being the rising star of Europe in the 1970s and 80s it has become the new ‘sick man’.

ECB as Saviour

Without the fiscal union and mutualisation of debt obligations which would have accompanied a full integration of the EU, countries in trouble came to rely on the auspices of the European Central Bank (ECB), its executive authority and reach, and its various emergency funds to save them from insolvency.

Ingeniously, without deeper integration, the ECB actually became the tenuous financial root system keeping the whole alive.

The game ended with the GFC.

Since then, the Eurozone had three choices argue Macquarie:

(a) embrace the inevitable logic of debt mutualisation (which the market participants and investors were effectively assuming prior to 2008) and supplement the monetary union with a fiscal union; or

(b) force the periphery to undergo massive domestic deflation; or

(c) encourage weaker members to exit the € project. It was the domestic deflationary route that was chosen, with ECB acting as the shock absorber.

What this Means for Investors

For investors, Macquarie warn the recent cyclical recovery in the Eurozone masks deep fractures that continue to undermine the Euro, and choices are getting harder.

"Monetary union must be complemented by fiscal union and mutualisation of debt; or the Euro is ultimately doomed," say the authors. "Alas, it is highly unlikely that the forthcoming elections will support fiscal union, debt mutualisation or sizable domestic stimulus by surplus states."

Indeed, a deeper integration seems even further away than it did before during Europe’s heyday at the start of the millennium.

And Germany must take a leading role:

"If Germany reduces its surpluses and stimulates consumption, it would allow the periphery to recover. However, no German stimulus = no rebalancing; the Eurozone therefore has to try to export its domestic adjustment, in a world where other states are doing the same."

And it is striking that Macquarie believe Italy, not China, is the biggest risk the global economy faces:

"The Eurozone is also about to discover discomfort of inflation and that it might be worse than disinflation.

Interest rates and exchange rates are becoming too low for Germany but too high for Italy or Greece. In the absence of fundamental change, Italy remains the key global risk; far more than China (here).

"Since 1999, its industries and banks were devastated, and it is unable to either improve competitiveness or devalue.

"Any contraction of liquidity without fiscal stimulus could finally force Italy’s exit. Prisons look tranquil until inmates revolt. It all looks quiet now but any significant volatility spike could lead to an Italian riot and it is 10x the size of Greece, with a total debt burden exceeding €6 trillion."

 

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