In 1991, a dozen European countries signed the Treaty on European Union, also known as the Maastricht Treaty. Among other provisions, the treaty called for a single European currency: the euro.
Three decades later, the euro, now the national currency of 19 European countries, is under immense pressure. Since 2008, the euro’s value has fallen by nearly 40% against the dollar.
The Challenges of a Single Monetary Policy
Monetary policy for the eurozone is set by the European Central Bank (ECB). But a single monetary policy for all 19 eurozone members has proven to be a near-impossible challenge. The countries in the eurozone operate at two speeds: relatively fast in northern Europe (Germany, the Netherlands, Luxembourg, and Ireland) and sluggish in southern Europe (Spain, Portugal, Greece, and Italy).
The Global Financial Crisis and Its Aftermath
It wasn’t until the global financial crisis began in 2007 that cracks in the euro’s foundation became clear for all to see. A key concern then, and now, was inflation. While the ECB had kept interest rates low to accommodate the slow-growing southern European economies, producer price inflation in Germany was rising at an 8.1% annual rate by June 2008.
By then, the global financial crisis was in full swing, spreading to Europe. Banks in Portugal, Italy, Ireland, Greece, and Spain teetered on the brink of insolvency. Several of these countries’ governments were also unable to repay or refinance their sovereign debt.
The Greek Debt Crisis
Greece was the worst-affected country.
In 2009, the Greek government announced that its budget deficit amounted to 15.4% of its GDP. Greek borrowing costs spiraled upward as credit rating agencies downgraded its sovereign debt to junk status. The Greek government formally requested a bailout in early 2010.
Over the next few months, the EU took steps to support Greece and other eurozone members facing financial crisis. In 2010, Greece received a €110 billion joint EU-IMF relief package, with about one-quarter of it contributed by German taxpayers. In exchange, Greece agreed to austerity measures, including billions of dollars in budget cuts and tax increases.
ECB’s Response and Cyprus Bail-In
The ECB also cut interest rates from 4.25% to 1% to further ease pressure on southern Europe’s economies and extended more than $1 trillion of low-interest loans to eurozone banks.
In 2013, Cyprus requested a financial assistance package after its banking system collapsed. This package was unique in that, for the first time, it required bank depositors to share in the cost of the bailout; this came to be known as the “bail-in.”
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The European banking crisis of 2016 and its domino effect
Impact of COVID-19 and Rising Inflation
When COVID-19 reached Europe, lockdowns imposed in response led to a collapse in growth – more than 12% in the eurozone by the second quarter of 2020. In response, EU leaders established a €750 billion recovery fund mutually guaranteed by all members. These funds were distributed to member states as grants and loans.
Meanwhile, inflation rekindled. By October 2021, inflation across the eurozone was at 4.1%, with producer prices up even more.
The Ukraine Conflict and Energy Crisis
On February 24, 2022, Russia invaded Ukraine.
In the days following the invasion, European countries invoked a far-ranging series of economic sanctions against Russia. Russia responded by reducing natural gas exports to Europe. Overall, Europe produces only about 17% of the natural gas it consumes. Of the 83% it imports, almost half originates in Russia. Its primary use is for power generation and heat.
The stark reality that Europe faces this winter is that it won’t have enough natural gas to meet electricity, industrial, and consumer demand. In Germany and other countries, emergency gas contingency plans have been developed to determine which companies should be cut off first. These companies will then be forced to temporarily shut down and furlough their employees. Consumers will need to lower their thermostats to pay soaring energy bills.
Potential Revolutionary Upheaval
A society with a large enough population of cold and unemployed people risks potentially revolutionary upheaval – one that could have profound implications for the euro.
How the Euro’s Demise Could Begin
Since the euro was introduced two decades ago, German taxpayers have borne the brunt of the expense of loans by the ECB to the most indebted eurozone banks and governments. German euro-skeptics have long argued that ECB’s longstanding easy money policy would eventually lead to inflation. And consumer prices are rising in Germany at double-digit rates. Producer prices are increasing even more quickly, at a stunning 45.8% annual rate.
Political Implications in Germany
The political implications of these developments can’t be overstated. Virtually every adult German has a parent or grandparent who experienced the hyperinflation Germany suffered in the aftermath of World War II. And those grandparents were raised on stories from their grandparents of the hyperinflation of the 1920s that helped Adolf Hitler and the Nazis take power in 1933.
Euro-skepticism in Germany also won’t be helped by the latest announcements from the ECB. In July, it introduced its latest instrument to help the eurozone avoid what it remarkably honestly called “fragmentation risk.” The ECB calls it the “transmission protection instrument” (TPI).
The Transmission Protection Instrument (TPI)
According to a press release following the announcement, the ECB will use the TPI mechanism to buy securities in countries that are “experiencing a deterioration in financing conditions.” The idea is to pre-empt any political initiatives that would risk defections from the eurozone. But that policy conflicts with the core responsibility of the ECB to control inflation.
From 2014 until July 2022, the ECB kept interest rates below zero. To help fight inflation, it’s increased the deposit rate that banks receive for overnight deposits with the central bank to 0.75%.
Rising Debt Yields and Inflation
But as the ECB increases interest rates, it becomes more difficult for weak borrowers to service their loans. Italian sovereign debt yields are approaching 5% and its debt-to-GDP ratio is now 150%.
With producer price inflation in Germany approaching 50%, it doesn’t seem outlandish to suggest that a political movement blaming the ECB’s easy-money policy for rising prices might gain traction.
Potential Legislative Changes in Germany
John Butler, the editor of the UK-based Fleet Street Letter, suggests one approach Germany might take would be to enact legislation which would:
…adjust Germany’s contributions to the EU to reflect any disproportional reduction in ECB purchases of German government bonds vis-à-vis those of other euro member countries. So, were the ECB to reduce its relative purchases of German bonds by, say, 10%, Germany would automatically cut its EU contributions by 10%.
In the minds of German voters horrified by inflation and angered at their country’s disproportionate contributions to the EU, this proposal might sound eminently reasonable. But merely proposing such a law could be the catalyst for yet another eurozone crisis.
Potential Consequences of ECB Bond Purchase Adjustments
If Germany were to tie ECB bond purchases to its contributions to the EU, and the ECB is unable to buy distressed eurozone debt, the shortfall could lead to a wave of bank failures across the eurozone. The worst impacted economies would be Italy and other heavily indebted southern European countries.
Their governments would likely nationalize the failed banks, perhaps in combination with Cyprus-style bail-ins. That will lead to even higher debt-to-GDP ratios in these countries and much higher interest rates for their euro-denominated debt.
What Happens if a Country Leaves the Eurozone?
At some point – perhaps as early as this winter – we could reach a tipping point. Multiple southern European countries could throw in the towel and relaunch their own national currencies.
Let’s say that Italy pulls out of the euro and reintroduces the lira as its national currency, as leaders of the right-wing coalition now governing the country have previously suggested.
Impact of Italy Leaving the Eurozone
It seems inevitable that the lira’s value would plummet against the euro instantly. And that would make it even harder for Italy to pay back its gargantuan debts, which are primarily euro denominated. A default would be inevitable.
Italy and other countries exiting the euro would likely impose foreign exchange controls to prevent capital flight, as Greece did during its most recent financial crisis in 2015. Withdrawals from bank accounts would be restricted, and domestic bank deposits in euros could even forcibly be redenominated into the national currency. Domestic depositors might or might not enjoy exemptions from these requirements.
Consequences for Less-Indebted Countries
Citizens of less-indebted countries like Germany would be substantially better off than those in countries like Italy. Still, there would likely be a prolonged fiscal shock when it becomes obvious that the ECB’s obligations – billions of which are held by German banks – will never be paid off.
But when the dust settles – especially when Germany once again enjoys stable energy supplies – its citizens will experience a comparative boost in their living standards compared to citizens in other European countries with enormous debts.
Is It Time to Buy in Europe?
Meanwhile, Americans are enjoying the effects of having the dollar trade at the highest level against the euro in two decades. And they’re flocking to Europe to buy real estate there. The hottest eurozone markets at the moment for buyers with fistfuls of dollars are in France (Paris and Provence); Italy (Tuscany and the Lake Como region); and Portugal (Lisbon).
Other buyers are holding off. They are waiting for the euro to go even lower and approach its all-time low of 0.82 against the dollar, which it reached in 2000. And while we don’t have a crystal ball, it seems reasonable that if the Federal Reserve continues to hike interest rates, the euro could continue its downward plunge.
The larger question for dollar investors considering investments in Europe, and particularly in the eurozone, though, is this: How would the demise of the euro, if it occurs, affect the value of those investments?
We don’t have an answer to that question. But it seems fair to conclude that if the euro dies, investments in European countries that aren’t forced to devalue their national currencies against the dollar will fare better than those that are.
It’s going to be a wild ride – and one that we plan to sit out.
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