As of this moment, Europe has over 181 million confirmed cases of the novel COVID-19 virus, and over 3.91 million deaths. Amid the coronavirus-induced panic-selloff in global equities in March of 2020, regional benchmarks like the DAX lost over half a decades-worth of gains in a month. Markit PMI for the same month printed record-breaking low figures that made the 2008 financial meltdown look like minor deviations in economic activity. The immense magnitude of both those events, and how Europe is still recovering from it today – financially, economically and politically – underscores the destabilizing nature of the virus. For the Eurozone and its members, it is acting as the ultimate test of Europe’s resolve of unity. The fundamental question is: will the friction lead to fracture or fraternity?
Sanctuary & Sin: Rushing Peace
To better understand Europe’s current predicament, it is crucial to identify Europe’s key structural problems and what catalysts widened these regional, multidimensional fissures. One dates back to the very creation of the Eurozone itself. This section will provide a brief, general overview to contextualize the subsequent chapters.
Haunted by the pain of two world wars, European officials sought to find a way to end intra-regional conflict. Through a series of treaties that wove Europe closer together, the end result was a union and the creation of the European Single Market, underpinned by the so-called Four Freedoms: the free movement of goods, capital, services, and persons. In this regard, the European Union and the Eurozone can arguably be seen as a project that used economic means to achieve a political end: peace. Europe was eager to repair its political wounds and create regulatory parameters – like the Growth and Stability Pact – to facilitate convergence that would allow the Eurozone as a currency union to function optimally. However, these rushed measures, put ahead of other considerations, were the proverbial original sin.
A major critique of the Eurozone is the lack of key institutions that could have been used to smoothen out regional asymmetries that exist today. Some economists have argued that they should have come embedded with the original plan of the currency union or at least have been created shortly after.
These include provisions to account for severe divergences in interest rates among Eurozone members, policies to address asymmetric recoveries from shocks (see below), and for export/import balances that would ordinarily be rectified with a flexible exchange rate. One policy that continues to be hotly debated is the issuance of so-called Eurobonds that are backed not by individual countries but by a collection of them. This would mean lower interest rates on sovereign debt that might have otherwise been higher e.g. Italy, Greece, Spain relative to Germany and France. The yield differential could allow structurally-distressed states to use those freed up funds to implement growth-stimulating policies and move toward greater convergence.
However, one of the conditions of forming a currency union means a single monetary policy for all of its constituents. But as Nobel Prize-winning economist Robert Mundell notes in his assessment of the Eurozone, the nature and identity of each European member is “too diverse to easily share a common currency” (The Euro, p.87). These include cultural and demographic factors that become pronounced during times of crises – and a housing bubble burst in the early 2000’s was the perfect catalyst. Competing priorities due to the asymmetric nature of the shock that hit the continent meant different policy prescriptions were needed to address unique situations in each Eurozone state. However, the relatively rigid nature of the Eurozone prevented such accommodations, consequently creating the tinder of resentment that would later burn when other crises hit.
The (Debt) Prisoner
Following the famous crash of the collateralized debt obligation (CDO) market in 2008 – and all its interconnected network of precarious debt instruments – the contagion spread to Europe. Portugal, Spain, Italy, Cyprus and most-famously, Greece were hit hardest. They all subsequently suffered severe debt crises as fears of insolvency began to spread like a pathogen. The perception that these countries would not be able to pay off their debt caused borrowing costs for their sovereign-issued bonds to surge. Between July 2011 and March 2012, Greek 10-year bond yields spiked almost 200 percent from approximately 14.5% to over 41.4%. During that same period, Italian and Portuguese borrowing costs also spiked, though not at the same magnitude as Greece. The country then descended down a staircase of economic and financial despair, with each step down incurring a greater debt of misfortunate; both literally and figuratively. The spiral went something like this:
Growing perception that Greece would not be able to pay back its debt → interest rates then rose as a reflection of investors demanding a higher yield for what they perceived to be an increasingly riskier investment → higher interest payments fed the narrative that surging borrowing costs make repaying its debt even less likely → interest rates rose → ad infinitum.
To avoid defaulting on their debt, the Greek government accepted loans that were attached with austerity conditions. These provisions laid the foundation for what would later become a “mobilization of resentment” among a disgruntled populace. Protests and riots subsequently ensued, ultimately culminating in what would become a small-scale humanitarian crisis. The Greeks lacked a diverse set of tools to combat the economic and financial turmoil by virtue of their commitments to the structure and rules of the Eurozone. Being part of that currency zone meant they lacked independence in monetary policy, and regulatory constraints prevented the government from using bold fiscal measures. It instilled a sense of powerlessness in the face of a recession and social unrest that would later form the basis of wide-spread euroscepticism that haunts the continent to this day. The crisis exposed the institutional rigidity placed on Eurozone member states, and the divergence in preferred policy prescriptions between Germany, the IMF and ECB versus Greece amplified regional tensions. The North-South divide would continue to widen and make intra-regional reconciliation more difficult as the words and rhetoric from both sides would cross the precipice and fall into the fissure that separates them to this day.
The Gunslinger: Italian Fiscal Exceptionalism
The North versus South narrative would again resurface in 2018 with the Italian general election. 5-Star Movement (M5S) leader Luigi di Maio and Lega Nord party leader Matteo Salvini both became Deputy Prime Ministers with Guiseppe Conte as the Prime Minister. Without getting into the labyrinth of drama that occurred between the two parties, the main takeaway was the structural uncertainty embedded in this newly-formed government. The instability of the situation was not lost on investors.
The day of the election, the Euro plunged against the US Dollar and Swiss Franc while the spread between Italian and German debt yields significantly widened. The volatility in financial markets was a reflection of investors demanding a higher premium for holding Italian sovereign debt that they saw as comparatively more risky with the new coalition. Salvini and di Maio were on opposite ends of the ideological spectrum, but the thread that knit this relationship together – before it was torn apart at the seams – was a clear underlying Euroscepticism. Both leaders tapped into the anger and frustration of their constituents who were feeling powerless amid stagnant economic growth and dangerously-high unemployment rates, particularly among the youth. Much like Greece, Italy also lacked the ability to use monetary and fiscal tools to reinvigorate economic activity, and this is where the political fallout of the debt crisis would make its reprise: the perception that Greece lacked autonomy over its economic trajectory fueled Eurosceptic narratives that Brussels is a sovereignty-violating technocratic leviathan. Salvini and di Maio ran with this narrative, and what followed was a bold and disruptive set of policies that would rock the Euro and local bond markets.
If a trader looked at Italian 10-year bond yields from May 2018 – the month of the general election – through June 2019, he could construct the entire story of this political turmoil. For the sake of the reader, I will only provide key events in the Rome-Brussels tug-o-war timeline to avoid losing the forest for the trees.
As a way to revive economic growth, Salvini and di Maio put forward a proposal to expand the country’s budget deficit far beyond the recommended limits set forth by the European Commission. This is because Italy’s debt-to-GDP ratio stands at over 130%, and fiscal regulations constrict the ability of a country to run a bigger deficit once the country’s debt threshold exceeds 60%. This framework was put in place to avoid a country incurring so much debt that its ability to service these obligations becomes a point of doubt, consequently precipitating a sovereign debt crisis – like Greece.
However, the newly-formed anti-establishment government – by definition – was signalling that it was not intending on playing by the rules. Rome and Brussels subsequently engaged in a battle of budgets, and the Euro paid the price for it. The European Commission warned that if Italy did not adhere to the regulatory framework around budget deficits that they would impose the Excessive Deficit Procedure (EDP). This process involved a fine of up to 0.5% of GDP – roughly €9 billion. Italy’s fiscal exceptionalism was a dangerous game to play for two key reasons. First, an imposition of the EDP would reinforce the narrative that Italy lacks sovereignty and that an outside force is dictating Italian affairs unfairly. As a result, this would likely only fuel the Eurosceptic flame that continues to burn intra-regional cohesion. The second was that if Brussels capitulated and was allowed to incur excessive debt, it could destabilize the entire Eurozone if investors started to believe that Italy – the third largest Eurozone economy – would become insolvent. Furthermore, even if that reality did not come to fruition, the standoff against Brussels with Italy as the winner could have then inspired other Eurosceptic movements around the region to engage in similar efforts; “If Italy could do it, why can’t we?” would become the question.
Ultimately, a resolution was reached whereby they agreed upon a middle ground for debt and the country avoided the EDP. Having said that, this underlying narrative of country vs supranational organization and the perceived lack of autonomy would rear its ugly head again in a much more dire context.
The Reckoning: COVID-19
The unprecedented shock of COVID-19 sent the Euro tumbling against the US Dollar and Swiss Franc along with domestic equity markets. Spreads on credit default swaps for sub-investment grade bonds surged along with sovereign bond yields for structurally-distressed Eurozone states. To preserve financial stability, the European Central Bank (ECB) implemented a “non-standard monetary policy measure…to counter the serious risks” known as the Pandemic Emergency Purchase Programme (PEPP).
Echoing Mario Draghi’s famous “whatever it takes” moment during the peak of the Eurozone debt crisis, ECB President Christine Lagarde said in response to the PEPP program: “There are no limits to our commitment to the euro”. This robust continuation of unwavering devotion to the Eurozone strengthened the Euro by virtue of the resilience this statement signalled. Along with many other policymakers, Ms. Lagarde emphasized the need for a “coordinated” fiscal strategy to ensure economic activity is not only preserved but revitalized. The response was generally received well – that is, until negotiations began and the old wounds of the past returned with a vengeance.
Without getting into too much detail – more of which can be found in a timeline of articles I authored in the summer of 2020 – the internal rift between North and South stalled negotiations of a 750 billion Euro aid package. The biggest point of contention was over the loan-to-grant ratio of the rescue fund as well as the degree of oversight that would be tied to the distribution of it. Mediterranean states expressed trepidation in accepting loans that were stipulated to be monitored by institutions outside their borders; the dynamics of the Greek debt crisis rang an eerily familiar bell that Southern lawmakers had no interest in hearing again.
After much deliberation, the 27 member states and European Commission (EC) agreed to a 750b Euro aid package known as Next Generation EU. EC President Ursula Von Der Leyen announced on May 28 2021 that they are ready to “go to the markets to raise money”. This solidarity offered another lesson to Euro traders after the Eurozone debt crisis: don’t bet against European unity. But will this axiom expire?
Redemption? The Future of the Euro & Eurozone
Looking back but going forward, Eurozone states should remember that unity as a moral and financial value pays short, medium and long-term dividends. It is the basis for cooperation that gives investors a sense of stability – and quells fears of insolvency – and European constituents a reinforcement of a regional identity. The latter is the basis for multinational coordination, with the alternative being every man for himself.
The pandemic amplified Europe’s structural problems by placing greater pressure to resolve them at a time when global geopolitics were generally more belligerent than cordial. COVID-19 has and will continue to test the bloc’s resolve; but it may ultimately give way to an economic rebirth of Europe that had been held back by inward-thinking nationalism and elements of an out-of-touch bureaucracy. In the end, Europe’s friction did not lead to fracture but to a greater sense of fraternity; though internal fissures and wounds from the past remain. For the next crisis – and there will be another, though its timing, duration and depth is unknown – European officials will need to remember to embed multi-lateral unity at the center of their policy prescriptions. This is the way to elevate Eurozone stability and the welfare of its constituents.
The views expressed here do not necessarily represent the viewpoint of my employer or its affiliates
Dimitri Zabelin studied political economy at the University of California, Berkeley for both his undergraduate and masters. He then transferred his expertise to the world of foreign exchange where he authored reports on optimizing trading strategies for geopolitical risks. He currently works in data policy at the World Economic Forum’s Centre for the Fourth Industrial Revolution.
Picture credit: “ECB – Luminale 2016” by European Central Bank is licensed under CC BY-NC-ND 2.0