How Much Negative News Can The Euro Take Before It Breaks?

Includes: FXE
by: Hale Stewart

My opinion about the EU was best summed up in this piece which was re-posted over at the Big Picture blog:

And finally, there is Europe. I previously noted that Europe is currently in a situation akin to the US under the Articles of Confederation. We have a group a states who have created a liberalized trading code between themselves, but who also lack enough centralized authority to meaningfully implement effective macro level policy. The Greek situation is a great example of this problem. Greece has been fiscally reckless for some time (as in years); their budgetary policies were usually in violation of some EU covenant. However, the central EU authority didn’t have the requisite political power to stop Greece from enacting policies that violated EU dictates. So, the only way to actually solve the problem occurred when Greece was ready to default on its debt. Also consider the policy problem faced by the ECB; they have to set interest rate policy for strong countries like Germany and weak countries like Greece and Spain. In short, it’s an insane proposition from a policy implementation perspective.

It's a perspective which I currently have. At some point, the EU will have to come to some type of understanding about its need for additional centralized power, especially in relation to state budgets, in order to survive. I don't know what that relationship will look like, but there will have to be a change. I also don't think this will be a bad thing. The total EU area is one of the largest economic blocks in the world, and collectively represents a tremendous consumer and business market; they collectively have far more power together than apart. While some will of course argue that more centralized government is bad, these are the same people who always make that argument and who also, for the most part, know less about economics than any of my three dogs.

As I have watched from afar, my thought has literally always been that we are now at the point where the events will literally force the EU to make this change. I have continually been wrong in this assessment. In addition, I am beginning to wonder just how much negative news the regional block can take before it starts to fray. While it's easy to underestimate the resilience of an economy, it's also important to keep in mind that at some point, a system cannot take any more stress. While there is no way to gauge when this will occur with the euro, recent events obviously add pressure. Consider the following:

Italy -- a country which is in a recession -- had an indecisive election within the last three months. One of the leading candidates was a comedian -- obviously not someone who has any meaningful political experience or any ability to build a coalition. Another leading candidate was recently convicted of a crime. No one had a majority.

The economic numbers from the region as a whole continue to show an ongoing recession. The region as a whole has been contracting for the last five quarters. Unemployment is increasing. The manufacturing and service sector indices are showing contraction. The region is also in the middle of a love-fest with austerity, which recent research is contractionary. The economies that lead to the problems (Greece, Spain and Portugal) are still in terrible shape. France is teetering on the edge. Basically, there is little good economy news coming from the region.

And now we have problems coming from a small, offshore tax haven called Cyprus, whose banking sector has grown to abnormal proportions. Because these banks invested in Greek debt, their respective capital took a big hit as the Greek economy tanked. But because a large number of their depositors are thought to contain illegal gains (read Russian organized crime and general tax evaders from around the globe), the EU wants the banks to shoulder a large percentage of the bailout costs. This lead to the incredibly stupid idea of taxing depositors to obtain funds for the bailout, a policy which many commentators have speculated (correctly, I believe) would naturally lead to a bank run.

I want to stress that I'm not saying we're at a break-up the euro point. Frankly, I don't think we'll know we're there until we're caught off guard by an overnight statement from a country stating they're leaving. My concern is this: there has been a dearth of good news coming from the region for an extended period of time -- as in years. In addition, there seems to be little desire to do what is actually necessary to save the alliance. Economic policy is contractionary; proposals to solve problems (Cyprus) are terrible and ill-conceived and the political will to do something seems to be lacking (Italy).

I'm just not seeing a lot of good ideas or positive solutions coming from the region right now.

For more, see this from Brad Delong.

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