The Euro: a Nine-Year Crisis

Europe

It’s been a while now since we have seen much action in the ongoing European debt crisis. The “crisis” is now around 9 years old although it would be reasonable to say that it started when the Euro started, given that the problems are a function of the structure of the Euro currency system.

The latest flare-up has been from Italy. Italy has long been a concern, but not a problem until recent elections. Whilst things have seemingly settled down since the flare-up in early June, nothing is fixed and its highly probable that we will see more action down the track. With that in mind, I though it was worth revisiting the Euro mess in order to remind ourselves why these problems exist.

The Euro:

Below is an extract from a market comment I wrote back in September 2011

“The Euro was an ambitious project of joining 17 nations together with the same currency. The benefits were supposed to bring all nations together, make trade easier and for all members to prosper.

The key problem to the structure is that no country has their “own” currency. In using someone else’s (the Euro) and sharing the same monetary policy and of course exchange rate, persistent trade imbalances have caused debts in some nations to rise out of control.

To try and explain the situation better, lets look at a successful currency union – Australia.

Here in Australia all the member states (NSW, QLD etc) share a common currency. Although the broad culture, values etc are the same throughout the union, the economies of each state are different. Hence there’s persistent trade imbalances among our member states, just like Euro states. How are these dealt with? They’re addressed through our political structure.

Even though each state has their own government, the federal government has broad powers to tax and spend anywhere in any corner of the union. Therefore, they effectively say to Western Australia “we’re taking some of your wealth – via taxes – and re-deploying it to those less fortunate in other parts of our union” (e.g. Victoria).

Therefore, as a simple example, WA helps pay unemployment benefits and pensions in Victoria.

And this is the problem with the Euro union. With the imbalances between members, for the Euro to succeed in its present form it would be necessary for more prosperous nations to assist those struggling. Not pointless bailouts – a mechanism is needed whereby some of Germany’s wealth is taxed and then used to help pay for the staggering unemployment in Spain and Greece. No such “federal government” exists. The very prospect of such a federal government being created is obviously controversial – given the huge differences in cultures and values between members, it would seem difficult to create one – are the Germans really going to sign up to an agreement to potentially have their wealth confiscated in unknown amounts and sent to Greece on an ongoing basis?”

At the heart of the Euro crisis is the different economies tied together under the same currency. Same currency = same exchange rate = same monetary policy. With regard to this, the following chart is hugely enlightening:

What this shows is the exchange rates between the German Deutschmark and the Italian Lira and Greek Drachma from when President Nixon brought an end to the Bretton Woods system in 1971 through to the creation of the Euro in 1999. Look at the “% Change”. Yes, that’s right – in the 25 or so years prior to the Euro commencing, the Italian Lira had depreciated around 82% versus the Mark and the Drachma around 95%! And then bang – the economies got pasted together at a 1-for 1 exchange rate!

Euro Crisis “Solution”:

There’s one true solution to the Euro’s predicament – as described above, the solution involves completing the “union” with a European Government – a proper one, not the half-baked arrangements they presently have. The government would have the power to tax and spend throughout the entire union – just like the Australian Federal and the US Federal governments. No meaningful progress has been made towards this.

The problem with the Euro is quite well understood – the problem being that these differing nations with very different economies have major imbalances in terms of competitiveness. Ordinary, under a floating fiat exchange rate system where the nations have their own currencies you would get exactly what you got prior to the Euro – a major devaluation in the less-competitive nations. That’s not possible under the Euro.

Therefore, the “solution” embarked on is to basically get the less competitive nations more competitive via an internal deflation/devaluation – to somehow suppress wages and improve productivity to such an extent that the nation becomes competitive.

And what’s the impact of this strategy? This chart below shows Italian unemployment:

Above is the headline unemployment rate for Italy. And below is the unemployment rate for the youth category:

For comparison purposes, here’s the headline unemployment rate for Germany:

In other words, the end result of the “solution” is persistently high unemployment and a reduction in living standards in those less competitive nations as the screws are tightened on government spending and concerted efforts made to suppress wages and improve productivity.

Italy:

This brings us to Italy. As noted earlier, Italy has long been considered a major concern given it is the third-largest economy in Europe, has a very high level of debt and a broadly uncompetitive economy (the key reason for the debt in the first place).

As a side-note, it’s important to highlight that the reason why Italy’s government debt is a problem is because they do not control their currency! If they had their own floating fiat currency there wouldn’t be any problem. It’s critical to understand that – it’s frustrating to still hear people say things like “Australia needs to get a grip on their government debt or we risk ending up like Greece!”.

The catalyst for the recent Italy flare-up was their federal elections. Unsurprisingly, given the pain being felt in Italy, the electorate resoundingly rejected the political establishment that has held power since the mid-90’s in favour of populism. Initially, there was no decisive winner and it was this that was cited as the key reason for the turmoil. Finally, a coalition government was formed and things have since settled down. This is unlikely to be the end. The government is a coalition of the Five Star Movement and the far-right League. It seems that they aren’t “anti-Euro” as such, but they are certainly focused on putting an end to the austerity that’s been demanded of them and other highly indebted Euro nations.

What to expect:

Unless the new Italian government backs down, they are on course for major clashes with other European nations. They plan sweeping anti-austerity changes which do not adhere to the European Stability Mechanism.
Expect some brinkmanship ahead:

Italy: “We’re introducing these new spending programmes and some radical tax cuts.”
Euro: “You can’t do that – its against our agreements”
Italy: “We didn’t agree to anything…those agreements were with the former government
that’s been thrown from power”
European Central Bank: “If you don’t do what they say, we can’t buy your bonds in the market”
Italian Debt: “[Puke]”
Italy: “You don’t scare us…we’re going to do the right thing for our people…we want your
support, but we won’t back down”
Euro: “Err…umm…”

Realistically, at the end of the day I feel that compromises will be reached, just like they have been with Greece and those other nations. At the same time however, I would not be surprised at all if we hit some points in the coming year or so where we’re collectively thinking “….yikes, Italy might plausibly leave the Euro”.

How should this influence my investment decisions? What’s the trade?

Aside from periodical (and unpredictable) broad market turmoil, the Euro backdrop is not exactly positive – not just from the Italy mess, but more broadly. The economy isn’t proving as strong as many thought late last year/early this year when the “global synchronised growth” narrative was alive and well. The ECB is on-hold as far as interest rates go, while the US Fed is still on course for higher rates and reduced stimulus. The Euro has been weak versus the USD, and given the backdrop its reasonable to assume that theme stays around for a while. The chart below shows the Euro against the USD.

For those more adventurous, there will be trading opportunities in Italian government debt. Just pick your side – if you’re sure Italy’s new government will back down and they will pull through this without any haircuts or defaults on government debt, buy some bonds into the periodical panics. If you feel they won’t pull through, you can look to short bonds or buy credit default swaps in the calm periods.

Disclosure – Aviator doesn’t presently have any positions in Euro or Italian debt, although it may take a position in the future if an opportunity presents itself.