Will euro survive next year?

The irreversibility of the euro is no longer a dogma..An amount of turbulence can trigger the "perfect storm" destined to eclipse the single currency.

There is a good chance that the euro will not become adult. Hard to say what can trigger the perfect storm, but the candidates are many: the referendum in the UK, the victory of the Austrian Trump, the reappearance of Grexit, a new electoral stalemate in Spain, or all these things together. But even if the Brexit will be averted, the Green candidate in Austria overturn the result of the first round, Sipras able to convince Berlin and Brussels not to overdo it too much, and finally the Spanish elections will allow the birth of a new government; well in this case we have to wait the French and German elections under a possible immigrants crisis.

The point is that the attitude of the various governments on the ECB's monetary policy (QE) and tax policies (compliance with the fiscal compact) clearly shows that what a decade ago seemed well-founded, i.e. the irreversibility of the euro, it is quite over. In a 2006 article, Charles Wyplosz[1], talking about how the euro was established and consolidated, stated: “further evidence can be found by looking at the evolution of spreads. They have narrowed since 2001, an indication of increasing credibility of the euro. The main setback has come in the Spring of 2005 when, following the rejection of the Constitution draft, a number of observers have started to ask whether the Euro area could break down. Then an Italian minister publicly called for his country to actually abandon the euro and reintroduce the lira. The Italian spread doubled, from 14 basis points in March 2005 to 28 in June; the average spread jumped from 4 to 10 basic points.” Wyplosz then concludes: “This episode confirms the previous conclusions. Yes, the markets do react to important events but no, they do not take seriously the euro break out hypothesis. Not only is the 28 spread on Italian debt very low, it is still much below the level of early 2001.”

You read that right: no 140 and 280 basis points, but 14 and 28. Today, Italy and Spain are happy to have a spread of 142 and 147 basis points, while the French spread, which ten years ago was null, is now at 36 basis points. And these values depend only on  Draghi’s "whatever it takes" (July 2012), and the ECB's monetary policy. In fact it is not surprising that the markets would reset the spreads: a single currency implies equal rates. It's true that the Treaty forbade purchases of government bonds at auction, but the normal routines of the ECB is based on such securities. So the fact that behind the public securities there was the ECB,  was considered obvious by financial operators, as well as the Federal Reserve is behind US bonds and the Bank of England behind the British ones.

But in October 2010 Chancellor Merkel persuaded President Sarkozy to make public the "private sector involvement", i.e. banks involvement in case of default of a country of the euro area, making explicit an unofficial agreement which took place at the European Council in May. In theory such involvement would have to start after 2013, the expiry of an (informal) agreement with the banks, that were supposed to keep the Greek bonds. The markets did not believe the statement in Deauville, because in Germany there was a widespread opinion, founded in effect, that the French banks, which had the highest share of Greek bonds, were selling them. A month later (November 2010) Akerman, President of the Deutsche Bank, in a private meeting with Merkel and Schäuble, said that his bank would sell not only Greek bonds but also those of the countries most at risk. So Ireland and Portugal had to get out of the financial market and ask for help, while the spreads of Italy and Spain began to rise, reaching levels that existed only before euro.

Angela Merkel has subsequently admitted that the Deauville statement was not a success; but actually it was perfectly consistent with the views expressed by the German Government. Consistent with the decision of the bail-in of private banks, decided in August 2013, and concerning all the securities issued by the banks, even before that date; consistent with proposals to set limits to the amount of sovereign bonds by banks; proposals for now rejected by the majority of European countries. And from the beginning of the financial crisis it is well-known the opposition of Germany to any form of assistance that introduces forms of risk-sharing, even when the reasonableness of such interventions is clear.

Recently seven CEPR economists[2] argue in this way: “Many countries in Europe are currently facing severe fiscal constraints that make it hard to raise new revenue via taxation. Tax increases by each member state would reduce much-needed economic growth and add a higher excess burden of taxation. From the perspective of tax smoothing, issuing bonds is thus desirable. At the same time, the refugee crisis involves costs now, in securing borders and integrating immigrants, and benefits in the future, when integrated new EU citizens contribute to the prosperity of the member countries. Issuing bonds therefore is the appropriate form of financing these expenses.”

The same economists have written a CEPR Report (A New Start for the Eurozone: Dealing with Debt) which offer a way to manage the debts of the euro countries. No doubt about the need to address the problem, just think of the Greek case. But you need not enter into the merits of the proposal, because, like previous proposals, it has no chance of being taken into account. The problem is to understand the reasons for rejection; there is no doubt that a part of the German ruling class (the Bundesbank) has a strong desire to close the experience of the euro; but, in the case of the greater part, it is more likely that it is a mix of ordo-liberal and fear of the reactions of the public opinion. When Schäuble said that the election results of Alternative für Deutschland were due to the low (and even negative) interest rate policy of the ECB, he has given an explanation probably wrong, because the AfD campaign was all about the immigrants problem. However it is clear that the Germans investors are surprised and upset, as are banks and insurance companies in the country.

Obviously Schäuble should know that to attenuate the QE, i.e. a monetary policy (too) expansive, involves the need to cancel the fiscal compact and switch to an expansionary fiscal policy, both at Community level (euro bonds) and at the level of individual member states. Since this does not happen, it is politics, in the form of some election results, to determine the monetary earthquake, although it is difficult to predict the dynamic of what will happen.

[1] C. Wyplosz, European monetary union: the dark sides of a major success, Economic Policy, April 2006.

[2] Corsetti et al. Reinforcing the Eurozone and protecting an open society, Vox 4 May 2016.

Ruggero Paladini

Economist - Professor of "Scienza delle Finanze" at University "La Sapienza" Roma; Member of the Economic Board of Insight - ruggero.paladini@uniroma1.it