Can the Euro collapse?
It is my opinion that it is inevitable that the single currency will break apart. This is not any Eurosceptic wishful thinking, nor do I relish the havoc that this would cause. I do believe, however, that the internal pressures within the Euro are unsolvable and this will lead to its collapse. And it is all down to the bond market.
And it has major ramifications for the UK, despite us never having been a participant.
Interest rates can be defined as the cost of money. It is also a measure of risk.
Central Banks raise rates when they want to reduce the amount of money in circulation. This can help control inflation as it cools asset price increases and deters borrowing. If the Central Bank wishes to cool the economy, it is usually via interest rates. Similarly if they wish to stimulate the economy and aggregate demand they lower interest rates.
The rates set by the bank determine the lowest cost of borrowing available in the market and is reserved for the country itself. The state borrows from the market via issuing bonds, I.O.U.s with a fixed rate of interest and a set date of repayment. These bonds are scooped up by long term investors, and banks who use the bonds as collateral to lend against. In lending to the government the private investors are at the risk of default. If the country cannot pay back its debts the investor risks being cleaned out. The credit risk is reflected in the interest rate attached to the bond, the riskier the country the higher the rate of interest charged by the market.
And here is the problem.
The Euro effectively mutualises all Euro denominated Government bonds, as the ECB acts as a backup. Simply put, the Single Currency is a proxy Deutsche Mark. Germany, being the strongest economy, is the benchmark for the Euro. Consequently the market attaches a lower risk premium to other countries. It's OK to lend to Portugal because they cannot default. Sure there are higher rates attached to Portuguese bonds but not rates that adequately reflect the real risk of default. Portugal has the world's 45th largest economy yet because of its membership of the Euro it is able to borrow at 4%. Given that they have only just emerged from an international bailout programme, this is absurdly low. Greece is able to borrow at 7% despite owing €350+ billion, a debt they will never be able to repay, according to the IMF.
Interest rates are kept at below zero by the European Central Bank to stimulate growth, particularly in the southern periphery. But the incentive is for the countries to keep on borrowing. Since 2007 Spain has increased its national debt from €525 million to €1.1 trillion as a result of these low rates. Italy owes €2.2 trillion.
Germany has also enjoyed the low interest rates, and, as a result, of the low value of the Euro created by lower interest rates has a 9 percent share of the world's merchandise exports, larger than that of the United States, an economy that is four times its size. It is Europe's export leader and has strengthened its position as Europe's growth engine during the crisis as exports rebounded to grow by 14 percent in 2010 after falling in 2009.
Yet here is the problem. German economic growth now running at has brought back inflation, which has just hit 2.2%. With banks offering negative interest rates (they charge you to hold your money), savers (pension funds) are losing 3% of the purchasing value of their capital each year. In order to cool this inflation the Central Banks must raise interest rates - the stronger Euro also helps Germany with its balance of payments by making commodity imports, notably fuel, more affordable.
But taking rates from -0.15% will shock the markets and it is precisely the countries of the southern periphery who will feel it the most. Rates in Portugal will rise dramatically towards double digits, they will be unable to afford their repayments, and the country will default, banks will collapse (although most of them are zombie banks anyway, only kept alive by the ECB). Ditto Spain. Ditto Italy and Greece.
The current practise of flooding the market with more money will only stoke inflation higher, and buying of Government bonds has the effect of reducing the interest rates (yield) encouraging more debt accumulation in an inflationary part of the cycle. ECB bond buying, already at well over €1 trillion is only a temporary reprieve in any case as the bonds are not retired, the debts still have to be repaid.
Will Germany allow its savers and pension funds finance a continuation of reckless borrowing in the south? No. Rates will rise, and the Euro will fragment. Our only hope is that it is orderly.
We live in an ever more interconnected world and the consequences of the Euro break up will affect us, and Brexit will offer some protections but not total immunisation from this.
Trade will be disrupted as the Eurozone countries have to ditch their Euros and reintroduce their Escudos, Pesetas, Deutsche Marks, and so on. In particular trade in physical goods will be volatile as the new values of the currencies gets established, and our trade balances will be all over the shop. But, The City of London will do very nicely out of this, thank you as it is the world's number one financial centre. UK bonds will also appreciate as investors dump their Italian bonds and buy safer UK Gilts, driving down our long term interest rates. As the Euro is dropped as a Reserve Currency banks will be forced to buy pounds. As a safe haven London property will act as a magnet for capital fleeing the weaker countries, and temporary controls may have to be introduced. By the same token, assets in the ejected countries may look cheap and attract UK investment as they snap up bargains, but this will come at a cost of that investment being diverted away from projects in the UK.
Like all things in life, there will be winners and there will be losers, but righting the market is essential. Due to the mess that is the Euro asset values and trade balances have been utterly skewed one way and another, and it is essential for the global economy to begin to operate efficiently the repricing and rebalancing must happen. It is inevitable, and as I said, we must hope that it is done in an orderly fashion, or the chaos I described is equally inevitable. For once, I can honestly say thanks to Gordon Brown for not dragging us in, but please note this: if we had not voted for Brexit we would have been sucked into the Euro within a few short years, and we would be one of the countries facing this crisis.