Join our community of smart investors

The half-finished euro

The eurozone crisis could re-emerge at any time.
June 5, 2018

Investors should not be misled by last week’s resolution of Italy’s latest political crisis. The country’s fundamental problem remains, and it poses a threat to the future of the euro in its current form.

The problem is simply a lack of economic growth. Since it joined the euro in 1999 real GDP has grown by only 0.3 per cent per year and it is still lower than it was in 2007. Quite apart from the damage done to living standards, especially for young people, this has had two nasty effects.

One is that it has kept government debt high: it is equivalent to 127 per cent of GDP. This isn’t because governments have been profligate recently. They haven’t. In fact, they have run primary budget surpluses for the last 20 years – that is, taxes have exceeded government spending excluding debt interest. Instead, a lack of GDP growth has meant a lack of growth in tax revenues, so governments have been unable to grow their way out of high debt.

The other is that a stagnant economy has led to hostility to established political parties – hence the rise of the Five Star Movement and La Lega. As Harvard University’s Ben Friedman and Australian National University’s Markus Brueckner have both shown, weak economies lead to rising intolerance and to right-wing extremism. The rise of anti-establishment nationalist parties is the direct result of poor economic conditions.

And here’s the problem. In its current form, the euro lacks any meaningful way of getting Italy back to growth. There’s no fiscal union whereby faster-growing economies can support slower-growing ones. And there are insufficient policies to promote growth. The ECB cannot cut interest rates any more, and those governments in the region that have the space to loosen fiscal policy (such as Germany) are loath to do so. This leaves only hectoring demands that Italians change their ways – “more work, less corruption” as European Commission president Jean-Claude Juncker said last week – or calls for “structural reforms”. And as Dietz Vollrath at the University of Houston has consistently pointed out, these have only weak effects. The currency union in its current form is, says Llewellyn Consulting’s Russell Jones, “half-baked”.

Continued stagnation means that there’ll be continued calls for Italy to leave the euro. In the near term, it is unlikely to do so. Leaving the euro would mean replacing the euro with a new currency, which would automatically drop like a stone. That would mean a huge rise in import prices and hence a cut in the real value of both wages and savings, making Italians much worse off. It’s for this reason that only a minority of Italians now want to leave the euro.

As we saw last week, however, if investors believe there’s even a slim chance of this happening, they’ll dump Italian bonds because of the small but horrible risk that these might be redenominated into a currency much weaker than the euro. This would cause falls in share prices as the value of banks’ assets fall and not just in Italy: non-Italians held €685.6bn of Italian bonds at the start of this year.

This could do serious damage. Losses by Italy’s already fragile banks might cause them to curb their lending. Worse still, if it leads to even the slightest fear for their solvency we could see a bank run, as depositors try to withdraw their money. Even if such runs are unjustified, they can cause otherwise healthy banks to fail.

Also, higher bond yields mean higher borrowing costs for the Italian government. That would reduce the already limited room it has to use fiscal policy to stimulate the economy.

The eurozone has the tools to fight such crises, as Berenberg’s Holger Schmieding points out. The ECB could buy Italian bonds to hold yields down. And the European Stability Mechanism can provide finance for the government and to recapitalise the banks if necessary. Neither of these weapons is likely to be used quickly. But the mere possibility that they might eventually be invoked means there’ll come a point at which selling of Italian bonds will become very dangerous. That alone puts a floor under bond prices – although exactly where nobody knows.

Such solutions, however, don’t address the fundamental problem of a lack of real growth. That requires reform of the euro to permit looser fiscal policy in the region. One means of doing this, argues Princeton University's Ashoka Mody in a forthcoming book, is to restructure government debt. In his book Europe’s Orphan the Financial Time's Martin Sandbu shows that this can promote growth if accompanied by recapitalising banks. This is partly because it would give Italy space to loosen fiscal policy, and partly because it would reduce the fear of a future crisis and so improve business confidence.

For now, such reforms are a forlorn hope: nobody expects much progress towards them at the EU summit at the end of this month. Mr Jones warns that only a deeper crisis will give them sufficient incentives for progress.

This means investors face an obvious danger – that the eurozone’s crisis could re-emerge any time, with another rise in Italian bonds triggering fears about bank losses.

On top of this structural problem, we have a cyclical one. The eurozone economy is cooling off anyway: purchasing managers say that growth in the region fell to an 18-month low last month. Slower growth means weaker equity returns, political crisis or not.