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Where next for the Euro?

20 October 2015

After the Greek crisis, can eurozone members move forward for further fiscal and economic integration?

After a torrid summer of all-night negotiations, and a snap referendum followed by a remarkable volte-face, the Greek crisis seems to be resolved – at least for the time being. Existential doubts about the euro are now heard less often. Even when a Grexit seemed a real possibility, financial markets remained calm, with little sign this time of ‘contagion’ forcing up the yields on other peripheral countries’ bonds.

The eurozone has again survived intact. There’s nothing surprising in this for Stuart Mitchell, Managing Partner and Chief Investment Officer of SW Mitchell Capital, who sees the Greek crisis as ‘just part of the ongoing reorganisation of Europe’ and its resolution as ‘a crucial step in making the euro more secure while peripheral countries achieve competitiveness’. He points out that countries such as Spain and Ireland, which have taken the harsh medicine of austerity, are now more competitive, their economies growing strongly again. ‘There are signs of dramatic internal devaluation in peripheral countries that increase their competitiveness while they remain within the eurozone.’ And he notes that a vast majority – including Greece – want to keep the euro.

That the periphery accepted austerity in order to stay in the club was, he says, ‘a key political event’, opening up the possibility that ‘in five years the euro could be one of the world’s strongest currencies’.

Others see the Greek crisis as a different kind of watershed. ‘It is the first time a country has been forced to choose between leaving the eurozone and accepting what is demanded of them, and the first time the euro-elites have contemplated leaving a member state behind,’ says Matthias Matthijs, Assistant Professor of International Political Economy at Johns Hopkins University.

‘That is something fundamentally new,’ he adds. ‘A Rubicon has been crossed. It has made the euro more fragile in the long term.’

So can the eurozone survive as is, or does that depend on embracing further integration? Wolfgang MÜnchau, a Director at Eurointelligence, describes the current situation as dysfunctional. ‘It depends on decisions taken in all-night sessions. Creditors and debtors are moving in opposite directions. Whenever a crisis arises, the leaders of Europe take up highly nationalistic stands, playing to their domestic audiences. Even with the EU founder members, France and Germany, there could be some rupture. Leaders are no longer pushing for a new Europe.’

‘The current set-up in the eurozone is insufficient to prevent future crises, because when recession puts individual government’s finances under pressure, there is no mechanism to deal with it and thereby forestall financial markets, making the pressure more intense,’ says Professor Paul De Grauwe of the London School of Economics.

The necessary ingredients needed to form a successful currency union, according to many leading economists, include a single central bank with real powers as lender of last resort; closely aligned tax-and-spend policies, assuming that full-blown fiscal union is a step too far; and more political union, even if the eurozone only maintains the appearance of federalism. On all three counts, Europe still has a long way to go.

While there has been progress towards creating a banking union, that is mainly seen in the centralised supervision of banks by the European Central Bank (ECB) and the national competent authorities.

‘There is no real financial backstop backed by the weight of EU governments and no common deposit insurance to discourage savers from transferring funds to accounts in other EU countries [as happened in Greece],’ says Matthijs.

The ECB may have embarked on quantitative easing in order to kick-start growth, but its bond purchases are linked to the size of a country’s economy so it is obliged to buy German bonds rather than concentrating its firepower where it is needed.

Issuing eurobonds backed by all member states might offer a more economically viable solution in the long term, according to De Grauwe. But he thinks that political factors make this unlikely because Germany is strongly opposed to the pooling of member states’ debt obligations.

There are also serious differences between Germany and other key players on how to move towards further fiscal and economic integration. ‘Germany wants stricter rules and more transfer of sovereignty to a technocratic body dominated by itself, while France and Italy want looser monetary policy while retaining tax and spending powers,’ said Matthijs.

“Germany wants stricter rules, while France wants looser monetary policy”

This could develop into a fault line at the very heart of Europe. ‘France does not want to transfer tax-raising powers, which it sees as a very intrusive transfer of sovereignty,’ says De Grauwe. With the rise of populist parties in France, Italy, Spain and even Germany, traditionally pro-European politicians have to be seen to be guarding the ‘national interest’.

Matthijs notes that the possibility of Grexit could well return. If Greece’s economy survived a departure from the euro, politicians in countries such as Italy might be tempted by the prospect of an exit and the sharp currency devaluation that would likely follow as a means of escaping decades of economic stagnation. For a founder member to leave, however, would almost certainly sound the death knell of the euro.

‘The eurozone remains very fragile,’ says De Grauwe. Yet, by some measures, its economic base is stronger than that of countries such as the US or Britain that have long benefited from real political union, common taxes and a single central bank.

The eurozone as a whole is far less indebted than the Anglo-Saxons or the Japanese, Mitchell points out. ‘Total private- and public-sector debt as a percentage of GDP is far lower, and across Europe there are world-class companies, such as Airbus, Siemens and Bayer, that form part of the most effective industrial base in the world.’

Provided politicians remain committed to the European project, the euro’s recent crises might ultimately be seen as mere teething problems.

Currency Unions

It is sometimes said that the world’s only successful currency union is the US dollar. That may be true, in terms not only of its staying power but also it becoming effectively the world’s reserve currency.

But as Professor Richard Roberts of King’s College London points out: ‘There have been other currency unions that could be described as successful.’ Both the German mark and Italian lira replaced a multitude of regional currencies after these countries achieved political unification, and they survived multiple crises until they were voluntarily merged into the euro.

More comparable to today’s eurozone is the Latin Monetary Union, launched in the 1860s and comprising France, Belgium, Italy, Switzerland, the Vatican and Greece. ‘It was based on member countries aligning their coinages so that gold and silver coins minted in each country were of a standard weight and fineness of metal, and freely interchangeable across the area,’ says Roberts.

‘Most countries adhered strictly to the rules, although the Vatican was expelled for abusing the system, including issuing debased coinage, while Greece was only allowed to join on the condition that France controlled the minting of its coins.’

Otherwise, the Latin Monetary Union continued successfully until the First World War, when governments started printing money. It was formally wound up in 1927.

The Scandinavian Monetary Union, launched in the 1870s, allowed Sweden, Denmark and Norway to share interchangeable currencies and, again, says Roberts, ‘it functioned smoothly until the Great War threw their separate currencies out of alignment.’

The same fate befell the 1867 Austro-Hungarian Monetary Union, whereby the merger of two sovereign states with separate parliaments, budgets and government departments was underpinned by a single central bank and currency. But after 1914, the central bank lost its independence, the government started printing money four years later and the Habsburg Empire collapsed.

Currency unions were probably easier to manage when based on precious metals rather than the creditworthiness of paper currencies. But Professor Roberts says: ‘All such arrangements have huge potential to be abused by “free-riders”.’

Similar concerns over moral hazard underpin Germany’s current stand on the euro, which is why a continued diet of austerity and doing the least possible through bailouts are its preferred options for keeping the euro intact.

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