European Disunion – Financial Fragmentation And Integration by Evergreen Gavekal
This issue of the Evergreen Virtual Advisor (EVA) is our monthly edition of insights from our partners at Gavekal. Thankfully, its subject matter gives readers a chance to shift their focus away from America’s political circus, which seems to be growing more surreal by the day.
You will soon read that the US is not alone in experiencing the rise of anti-establishment political figures opposed to free-trade and immigration. (For those of you with a bit more time for intriguing reads, please click on this link to access a very personal piece from Gavekal’s Charles Gave on one of the root causes of Europe’s immigration crisis.)
On the other hand, for EVA readers interested in the ultimate speed-read, the following is a summary of the main article’s salient points:
- The grand European integration project—which brought the euro currency into existence in the late 1990s—was a flawed creation from the start.
- The prevailing political climate at the time prevented a full-scale union. Some type of crisis (such as the 2008 global financial panic) was needed to force the eurozone countries closer together. Since then, there has been halting progress toward tighter bonds.
- However, the flood of refugees from the Mid-East is working against this by threatening the essential open-border structure (known as Schengen).
- The refugee crisis is also fueling the rise of populist political parties, as has anger over European Central Bank (ECB) zero- and negative-interest-rate-policies that are threatening the income of Europe’s growing retirement class.
- The financial fragmentation since the Greek crisis of 2011 and 2012 (which caused, for example, German banks to shed Italian loans and focus on domestic lending) is aggravating the disunion forces. As a result, cross-border financial activity flows are declining.
- The European Union (EU) has been relying heavily on Greece and Turkey to provide sanctuary to the influx of refugees but this arrangement is fraying.
- The rising anti-union sentiment has made fiscal integration (like sharing tax revenues between northern and southern Europe) a virtual impossibility. Consequently, closer linkage is increasingly reliant on strengthening the eurozone’s fragile banking system and making it “trans-national” once again.
- While there are some encouraging developments in this regard, Europe’s great unification experiment is at considerable risk, one that will be hugely elevated this June should the UK opt-out of the EU (the so-called Brexit vote).
By Nick Andrews & Cedric Gemehl
The grand old men who conceived of a united states of Europe knew that a successful single currency demanded a modern federation with integrated monetary, fiscal and political institutions. Such a leap into the unknown was politically impossible in the 1990s, and their assumption (and perhaps hope) was that the less than optimal eurozone would suffer periodic crises, so creating the conditions for reform and a centralization of powers. Since the 2008 financial crisis kicked off, that script has played out, at least partially. The trouble is that few game changing reforms such as eurozone-wide deposit insurance or fiscal burden sharing have been adopted. Instead, the dominant political-economic forces impacting the region are spurring disintegration rather than the hoped-for integration.
While European financial markets remain relatively calm due to massive central bank money transfusions, there is a bigger question about the European integration project, and whether it has again reached a point when investors start to doubt its sustainability. European equities are down more than 10% YTD, the yield curve keeps flattening as investors bet on more deflation and yield spreads in the periphery are widening.
The threat of the other
The refugee crisis has shown the notion of European “solidarity” to be a sham. Last year Greece was told that if it did not obey the rules and accept a Brussels-dictated bailout it would have to leave the EU. Less than a year later stronger countries showed how to protect their national self-interest with eight unilaterally imposing border controls in a move that challenges the core European Union principle of “free movement” for labor and goods. The European Commission estimates that re-introducing internal border controls would impose immediate direct costs of between €5bn and €18bn annually—or 0.05% and 0.13% of GDP. The road haulage sector alone faces extra costs of €1.7bn to €7.5bn. An additional €1.3bn to €5.2bn of working time would be lost due to delays incurred by EU workers crossing borders every day to go to their jobs. And should border controls become a permanent feature, several studies indicate a more serious impact: France Stratégie estimate it could cut trade between Schengen countries by at least -10% while Bertelsmann Stiftung finds that over a period of 10 years, the EU as a whole would suffer a €500bn to €1.4trn hit to economic output compared to having no border controls.
Here come the demagogues
The refugee crisis has also spurred on populist political movements which were born out of anger at high unemployment and low growth. Even in affluent Germany, the third most popular political party is now an anti-immigration, anti-euro outfit that in last month’s regional elections challenged Angela Merkel’s Christian Democratic Union. Like other European populist parties, Alternative for Germany (AfG) is changing the terms of political discourse and forcing mainstream parties into more hardline positions. German leaders have even taken to blaming the rise of AfG on European Central Bank easy money policies which have hit the savings of pensioners. The overall impact is to force Merkel and other leaders to respond directly to domestic fears and limit the scope for the kind of compromises needed to deepen eurozone integration.
On the periphery, Spain has lacked a government since its inconclusive December election ruptured the two-party system. High unemployment, falling wages and endemic political corruption has spurred new parties such as Podemos which won almost 21% of the vote. Ireland also remains government-less after its February poll. Like Spain, the Emerald Isle is not especially Euroskeptic, with all the main parties being pro-euro, but the results have forced political actors to try and roll back reforms that impose economic pain. Something similar has been threatened by the one-time model pupil of Brussels, Portugal, where the socialist party has formed an anti-austerity coalition with the Communists.
Across the continent, Euroskepticism and angry nativism is on the rise. Poland’s new government is nationalistic, authoritarian and highly critical of Brussels. Along with other eastern European countries such as Hungary it has rejected any system that involves it taking a quota of refugees. Similar dynamics can be seen in the “liberal” Netherlands where Geert Wilders’s Party of Freedom has led many recent opinion polls and was successful last week in campaigning against a free trade deal with Ukraine that was the subject of a national referendum.
Perhaps, the biggest near term catalyst to European disunion is the UK’s Brexit referendum. A vote to leave would prompt an energy-sapping negotiation on the terms of Britain’s departure, but more importantly offer a clarion call to other Euroskeptic voters that there is an alternative to “ever closer union”. Even a vote to stay, especially if close, could energize other Eurosceptic movements to seek a looser relationship with their EU partners as the UK has managed to achieve with its renegotiation.
The other big force threatening to rent asunder the eurozone is financial fragmentation or the