Blain: The Euro Has Become A Monetary Trap (And Negative Feedback Loop)

Authored by Bill Blain via MorningPorridge.com,

“Where Alph, the sacred river, ran through caverns measureless to man down to a sunless sea..”

Just as I was getting into this morning’s Porridge the proverbial “Man from Porlock” arrived in the form of the Ocado delivery! (Extra points to anyone who can connect Porlock, Opium and this morning’s quote.) Result is I lost the thread completely… which is apparently happening all around the globe. (This morning had already started badly: my mental health is clearly frayed… for the second time this week I unthinkingly pored milk into my Earl Grey. Next week I’ll be going into my office and forgetting to put on a tie. This really is the end…) 

Back to markets… While the rest of the World will be focused on what Trump is going to say about China (Clue - he talks big before the event, but will disappoint), this morning’s rant is about Yoorp.

How many times have we heard some grand poo-bah Eurocrat herald a grand plan to advance the Union. This time its Ursula Von der Leyen (VDL) announcing the €750 billion Next Generation EU recovery fund to help the EU tackle an “unprecedented crisis” and a raft of new proposals for Brussels.

The Next Generation fund will be part of  €1.85 trillion EU budget devoted to addressing the crisis. That’s a lot of dosh for an entity that can’t get its books signed off.. The fund will comprise grants and loans from Brussels to parts of Europe suffering from the virus effects by focusing money on increasing productivity and competitiveness. That’s interesting - why has it now become a Brussels responsibility and not a domestic competency? Ah… Brussels knows best. 

Let’s not kid ourselves. It’s a political compromise designed to partially placate the 4 Frugal nations, quell the increasing doubts of the Eastern Members, stave off further dissent about budget contributions across the union by making them think someone else will pay for debt,  and plays into the hands of German politicians by setting clear limits on future debt mutualisation. Like all bad compromises it’s a bit of Camel – a horse designed by a committee. Brussels is betting it’s enough of a compromise to get it pushed through sceptical domestic governments. 

It’s also a power grab by Brussels – which reckons it can solve its budget crisis by running the fund, obscure the hold created by Brexit by setting precedent for allowing itself to fund massively in the global markets, and giving itself a greater role in setting green objectives as a pre-cursor to taxing EU members directly. It looks and smells like debt mutualisation – but without it being mutualisation. The Germans will be happy – their courts have already established a precedent for them to walk away on the basis they can retroactively declare it all ultra-vires.  

VDL says the Brussels knows best; the COVID crisis can ‘t be solved by countries alone. Actually… the virus is probably the best example of something countries and regions should manage from themselves. The success of Germany in testing for COVID was largely due to decentralised labs. The logistical failures have largely been exacerbated by centralised bureaucracy. 

Yesterday I wrote:

I don’t see problem with the plans for the EU to increase its budget to finance virus crisis recovery. It’s a wonderful, generous and brave initiative. If workers in Germany, and the rest of prosperous Europe, value increased European unity so highly let’s make it happen! If they wish to show solidarity, and are willing to pay the pensions of Southern European workers with their taxes funding these economies and everything else that goes with them, while sacrificing yet more of their democratic sovereignty to the unelected Brussels nomenklatura, then good luck with this laudable European initiative. 

I was being cynical. 

Lots of other commentators genuinely think it’s a great idea and massive positive step. They reckon it will restore growth and renew the march towards closer union within the European project. 

A digression: Europe has nothing to do with Alexander Hamilton

For some curious reason, even smart financial analysts have taken to equating the new EU Recovery Plan with US Founding Father Alexander Hamilton’s federalisation of US debt in the 18thCentury. I wrote a Porridge comment lambasting the Bloomberg story linking Hamilton and the Euro last week. 

I don’t know how familiar with history these writers are, but Alexander Hamilton was able to secure a strong and workable agreement on state funding and central banking between 13 colonies sharing (broadly) common culture, a shared history of 2/3 generations in the New World, similar goals and a single language. They were united after successfully banding together to throw off the oppressor’s yoke – chasing out the Brits. I would also remind readers that just a few generations later their shared culture broke down as the economic forces of slavery and industrialisation triggered civil war.

In contrast the Europeans have over 3000 years of history – of repeated warfare, the rise and fall of nation states, invasions, migrations, plague & famine, and share little common culture (except perhaps a general envy/dislike of the Germans). They are also divided by shared religion where tiny nuances in application led to the slaughter of millions in the name of the same God . The only common language is English – and less than 2% of the Union have it as a mother tongue (and even they would claim to speak something else…) Europe does at least share a common enemy – historically that’s been themselves… If there is a discernible trend, its generally France vs everyone else on a rotating basis. 

Push a Europhile hard enough and he/she will claim the European Union has avoided war between member states. A bit like the Roman Empire then? It was founded as a trade agreement, a common market, but over the years its morphed into a grand and enticing vision (for Brussels Eurocrats) that the tired and exhausted nations of Europe can pull together as a genuinely  United States of Europe. 

Back to the main story.... 

I don’t have any problem with a unified Europe. I just don’t see how it happens. 

At the moment the project is at an impossible stage: it is a monetary union without political union. National Governments serve their electorates to deliver growth, jobs and prosperity, but have lost the ability to so in times of crisis because of the rules of monetary union.  

The nations of Europe want to go their way, but the money wants to go another – which is the crisis at the heart of Europe. The shared common currency rules need to bend in times of crisis –but it’s the lack of flexibility that is causing the ongoing crisis. Such flexibility requires the agreement of each sovereign nation. The recent decision to the German Constitutional Court to declare QE as potentially outside the remit of the ECB highlights the issue. Turkeys don’t vote for Christmas.

As a result, the Euro has become a monetary trap and negative feedback loop: 

  • Nations that control their own currency can print money to finance fiscal recovery through recessions – and run the risks of devaluation and inflation if they squander credibility while doing so. 

  • Euro members lose the ability to print money  – and are constrained by rules on debt. In times of crisis highly indebted nations have no choice but to enact counter-cyclical austerity policies to get debt ratios down… It’s happening again as we enter the next European Sovereign Debt Crisis. 

To avoid crisis and sustain confidence the EU is being forced into a negative loop to deflate the European economy with negative interest rates and QE Infinity. Just as nations are trapped into austerity, the ECB is trapped into backstopping markets. It will almost certainly raise the QE thresholds next week and continue to expand its buying remit to avoid Italy becoming the spark of the coming crisis. 

Italy’s debt to GDP was 134% before the crisis. It will likely see negative growth through 2020 and debt soar to 160% of GDP. It’s going to look like Greece on steroids. Like Greece it will have little choice but to remain within the Euro so that Europe continues to guarantee its solvency, but trapped in long-term austerity. 

Clearly Italy needs help… but it’s unlikely to come from a politically driven European Recovery Fund run from Europe – that will look like interference and push Italy into a Greece like conflict with Europe. Italy needs help today, not sometime next year when some kind of agreement has been reached by the 27 member states and the fund is up and running. 

2 week ago I said buy Italy on the basis the European Recovery Fund will look like a solution. Sure enough… it tightened.  Get ready to sell. In the next few weeks we’re going to see push back internally in Italy, and from across the EU.