A key advantage of Brexit is that it will, in time, reduce the UK’s dependence on the dysfunctional and slow growing EU, and insulate us to some degree from any renewal of the Euro crisis. The referendum was played out in the latter stages of the last Euro crisis, and concerns about the EU’s economic future did play a role in the vote to leave the EU. Since then, although debate rages of many aspects of Brexit, the EU’s weak economic fundamentals scarcely get a mention. Primarily this is because the EU economy has shown some cyclical recovery in the last two years, and the Euro itself has strengthened. However, because this recovery is based on very shaky foundations and because the Euro’s fundamental flaws remain, a new Euro crisis may only be months away.
Let us remind ourselves why the Euro’s long term survival is in doubt. The Euro is fundamentally a political project, imposed by the leadership of the EU in spite of it not meeting any of the key conditions for a successful currency union. The members of the proposed union had different cultures, legal systems, languages, and wildly divergent economic histories, structures, and cycles. Perhaps most crucially there was no democratic acceptance for the large fiscal transfers required between the stronger and weaker parts of the union in order to hold it together in crisis. It was hoped that by forcing the countries together in a currency union their economies would slowly converge. In practise the outlying, weaker economies – most notably Greece, Spain, Italy, and Portugal (arguably France as well) – diverged even more.
Without the outlet of a weaker currency the higher inflation and lower productivity of the weaker nations led to them becoming ever more uncompetitive and indebted. Instead of Germany and the other stronger nations being willing to transfer resources to the weaker nations to compensate, the EU imposed massive austerity on them. This austerity resulted in virtually permanent recession in the weaker economies. Threatened default by Greece led to the pre-referendum Euro crisis. Faced with this existential threat the ECB embarked on a huge reflationary effort to boost the EU economy and save the Euro. This comprised extreme measures never used before, including negative interest rates on deposits and a massive programme to buy government and corporate bonds – generally known as Quantitative Easing, or QE -to push down long term borrowing rates. Assets on the ECB’s balance sheet now approach 45% of EU GDP.
These policies have succeeded in raising economic activity – given their scale it would be astonishing if they had not – but have not changed the underlying negative dynamics of the Euro system. On the contrary, they have worsened them, because they have vastly increased the size of the ECB’s balance sheet and filled it with assets that are likely to sharply depreciate in value. The policies have also resulted in a rapid increase in so-called Target-2 balances. These arise because when, say, Italian bondholders sell their bonds to the ECB they choose to hold the proceeds outside Italy (usually in Germany). This loss of liquidity from Italy further weakens economy, so to compensate the German Bundesbank deposits equivalent sums back into Italian banks. These sums then become additional debts of the already hugely indebted Italian economy. In Nov 2017 Italy’s target 2 debts amounted to 435bn Euros – nearly 30% of GDP, over and above the official government debt ratio of 132% of GDP.
There are at least three factors which suggest that this “can kicking” process by the EU is coming to an end:
*Firstly, global interest rates – led by the USA – seem to have embarked on a rising trend. The US Federal Reserve is both raising its short term interest rates and reversing its own QE programme – that is selling rather than buying bonds. President Trump’s fiscal policy of cutting taxes and raising government spending – at a time when the current US economic recovery is already one of the longest on record – will put further upward pressure on US interest rates.
*Secondly, the ECB’s QE programme seems to have reached its natural limits. The global trend of rising rates is itself a constraining factor. The more hard-line elements in the ECB, led by Germany, have long been uncomfortable with the radical nature of these measures and are increasingly calling for them to end. The programme itself set limits to what proportion of bond issues, and of what type, could be purchased and many of these limits have now been met. The ECB has already begun tapering its monthly asset purchase programme.
*Thirdly, the recent Italian General Election resulted in big gains for parties that are either opposed to the Euro or propose to abandon EU-imposed austerity measures. The Lega Nord leader, Matteo Salvini – who could conceivably be Italy’s Prime Minister within a few weeks – has called the Euro a “crime against humanity”. The other non-traditional parties are not specifically anti-Euro, but their proposed policies would undoubtedly breach the rules of the monetary union in a major way. The EU was able to surmount the Greek default crisis by dint of extraordinary economic measures, and by putting enormous political pressure on a small country until it buckled. Those extraordinary measures cannot be repeated. Italy is a much bigger economy and founder member of the EU that cannot be pushed around like Greece has been. Italy’s debts are so large – both in relation to their own economy and in an EU context – that any measure of default would probably be fatal to the Euro as it currently exists.
The Impact on Brexit
If this analysis is correct this “forgotten” issue in the Brexit debate may come back into focus just as the key Brexit UK-EU end state negotiations are underway. What impact might this have? I am confident that a renewed Euro crisis will increase support for Brexit in the UK. It would also almost certainly undermine the credibility of those in the Remain camp who plan to try and stop Brexit just at the time when they aim to be exerting maximum pressure. (It is remarkable how many in the Remain camp – blinded by the size of the EU market – are unable to see its manifest structural weaknesses).
How might a renewed EU economic and political crisis impact on the Brexit negotiations? Rationally, it should make the EU keener to reach a free trade deal with minimal restrictions – failure to reach a deal could only worsen the economic crisis. Conversely, such a crisis might splinter the EU’s hard won unity to such a degree that decision making becomes more difficult and less rational. It could go either way. It is in the UK’s interest that the EU does not go back into crisis mode. If it does, it might be at least preferable that it erupts after negotiations are completed. However, I am reminded of Harold Macmillan’s observation – when asked what gave him most trouble as PM- that it was “events, dear boy, events