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The Dramatic Slowdown in Germany Threatens Another Euro Crisis

Investor's Notebook

‘If membership of the Eurozone had been confined to the original ‘Deutschemark Block’ – Germany, France, Holland, Belgium and Luxembourg which met the Euro’s initial convergence criteria – the Euro could have been a success. However other countries that did not meet the entry criteria but were nevertheless welcomed into the currency. Recent problems have demonstrated that the weaker applicants should have been made to wait until the Eurozone’s convergence criteria were achieved before replacing their domestic currencies with the Euro, but as is so often the case, politics trumped economics and these members are now living with the consequences. Uncompetitive exchange rates, continued austerity, high unemployment and falling wages among the weaker economies have exposed the Eurozone to the risk of political turmoil as disgruntled voters turn to parties that promise to end austerity and fiscal discipline. Herein lies the threat to the Euro.’

Pricing is a function of supply and demand. The greater the demand and the lower the supply, the higher the price. This truism also applies to money. If the supply of money is limited, then its value can be underpinned. If the supply of money is infinite, then it requires a trick of confidence if its users are to trust its value. The Euro shows many signs of danger but given the strength of its backers the currency will survive. However, its continued use by economically weak, impoverished and indebted nations will inevitably lead to further protests and protest votes in countries where voters are fed up with high unemployment and falling living standards. This has already brought about the election of politicians that promise to disrupt the political status quo and end the austerity imposed upon them by the Euro. For the Euro to survive in its current form, its members will be forced to sign up to a United States of Europe – with not only a single currency but uniform taxation and centralised borrowing.

The inept introduction of the Euro has already caused distress to several Eurozone economies. Problems with currencies that have no intrinsic value are not exclusive to the Euro, but the Eurozone’s obvious internal economic inequalities provide cause to fear that the European currency’s days as an effective means of exchange and store of value could be numbered. The notes and currency that are today generally accepted as payment in exchange for goods and services are merely ‘Promises to Pay’ and for as long as users of the currency believe that a central bank’s promise is credible and that the borrowing country is therefore creditworthy, currencies are accepted in exchange for goods and services. But herein lies therub.

Since the French Revolution there have been many occasions when a nation’s currency has had confidence in its value so drastically undermined as to be rendered worthless. These have not been confined to corrupt third world economies but include France and Germany, and there have been two occasions since the mid 1970’s when the UK’s currency and banking system have come perilously close to a collapse in confidence, namely during the 1974 secondary banking crisis, and the queues of depositors outside Northern Rock’s branches following the Financial Crisis in 2008 also demonstrated a fear of insolvency. And we should not forget how close the Greek debt crisis came to undermining the Euro in 2009. A currency backed by an asset with a finite supply such as gold or even Bitcoin, cannot be easily debased through oversupply. An IOU is different because borrowers can and often do fail to honour their debts and with Greece, the absence of support from the European Central Bank (‘ECB’) would have already bankrupted the country and forced it out of theEuro.

Over the past decade, central banks in the US, Eurozone and the UK have issued vast quantities of IOU’s to refinance their dangerously indebted and under-capitalised banking systems. The combination of Quantitative Easing (‘QE’)and very low interest rates was intended to facilitate lending and provide a sugar-rush to kick start the Eurozone economies and, as a result, Europe has enjoyed a period of economic growth. However, while the strength of the recoveries in the US and UK have allowed QE to be dramatically reduced – and in the case of the US, stopped and reversed – the Eurozone’s less robust recovery has not.

*QE is a policy whereby a central bank buys predetermined amounts of bonds or other financial assets in order to inject money directly into the economy.

A strong economy has allowed the US to push Dollar interest rates back up towards more normal levels without choking off growth. This means that when there are signs of another slowdown, the Federal Reserve can and will decrease interest rates to protect the banks from bad loans and help to boost their economy. Thanks to Brexit uncertainty the UK has managed just one rather paltry interest rate increase from 0.5% to 0.75%, but there is at least some scope to decrease rates if necessary, and the continued growth in the UK’s dominant service sectors suggest that if and when the Brexit uncertainty is removed, the next move in interest rates could still be upwards.

By way of contrast, consider the Euro where, despite an economic recovery of sorts, interest rates remain belowzero – it costs a depositor 0.4% per annum to leave his or her Euros in the bank. As we approach the next recession, the European Central Bank (ECB) is therefore unable to provide any meaningful stimulus by reducing interest rates and will be forced to continue to print yet more Euros through QE to stave off deflation anddepression.

The Euro was a fundamentally good idea. The certainty that it provides for businesses trading with neighbours using the same currency and the absence of the cost of exchanging currencies, fully justified the currency’s introduction. But unless their economies converge, users of the same currency cannot for any length of time maintain separate and different economic policies and cycles. Imagine if Scotland and England maintained wholly independent economic policies and debt management rather than one implemented by a common central bank and treasury.

The Eurozone allows just that. Within certain EU constraints, Eurozone countries can have different tax regimes, but they cannot cut interest rates or de-value their currencies to stimulate their economies and make them more competitive.

One size fits all, whether you are Germany or Greece, and this is a fundamental weakness. Eurozone rules prevent countries from borrowing more than 2.5% of their Gross Domestic Product (GDP). Italy and France both borrow a higher percentage and are therefore breaking the rules and must decrease spending and/or increase taxation.

Otherwise they will be fined by the EU. Italians have decided that their belts have been too tight for too long and raised two fingers to Brussels, electing a coalition of populist parties from the right and the left whose common promise is to increase borrowing and spending above the EU limits to bring down unemployment and raise living standards.






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About Jo Welman

Jo Welman

Jo Welman is an adviser to Epic Private Equity and the Non-Executive Director for ARK Syndicate Management Ltd, as well as advising several small companies and individuals on the structure and allocation of their investments. His previous roles have included managing balanced portfolios at Barings, Managing Director at Rea Brothers (Investment Management) Ltd, and Executive Chairman at Brit Insurance Holdings Plc. He has also set up a range of fund management operations and investment groups. He graduated from Exeter University with an honours degree in economics.

Articles by Jo Welman

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