Divergence in the good times, convergence in the bad

The euro is falling apart before your very eyes. And stockmarkets haven’t reacted at all.

Should I add “yet”?

The news is certainly bad enough to sink markets. The global chief FX and rates strategist at Danish bank Nordea called it a freakshow.

Source: Twitter

As a former circus performer, of sideshow level qualities, I find that offensive to freakshows.

Did you know that premature baby incubators were made possible by freakshows? A doctor financed the development of his odd machines by placing the premature babies in them on display and charging gawkers.

The euro has its uses too, of course. Like making it easy for me to travel. But I’m not sure that’s worth the pain for millions of Italians and Spaniards…

The Spanish government is already preparing for another EU bailout. By announcing a huge raft of spending measures first… (It won’t be able to do so after going into administration – what a bailout from the European Stability Mechanism looks like.)

The Italian government has confirmed it will need access to the same funds, by officially denying it.

Realising that nations can’t hand over their fiscal reigns without triggering massive anti-EU sentiment, the European Stability Mechanism has created another new fund. It has less strings attached in return for financing. The condition is that the money can only be used in certain Covid-19 related ways – mainly Covid-19 related.

This allows governments to claim they’re not handing fiscal sovereignty to Brussels, while the oppositions can claim, without providing a credible alternative, that the government really is handing over control over their own budget. It’s a perfect compromise. Everyone can prove the other side wrong.

But the bond market doesn’t like it. Italian bond yields are on the march higher.

Source: Bloomberg

And Italy’s Target 2 liabilities hit an all-time high in April too.

Europe’s people may be in lockdown, but their money isn’t, yet. Target 2 measures capital flows, or in this case, capital flight. The record highs suggest a record amount of money has fled Italy for other European countries.

Ironically enough, as readers of my book How the Euro Dies will remember, Target 2 is actually a measure of how much money the eurozone system pumps back into Italy in order to make up for the lost money from capital flight. The Germans have to send their euros back south again to make up for the shortfall from the Italians sending their money to safety in Germany…

Not that Target 2 is top of the news cycle. That’d be the European Central Bank’s QE policies.

Remember, the eurozone is the only place that has constraints on money printing. That means a proper crisis is most likely to begin there.

Other nations can simply print money and hand it to the government to spend. This kicks the can very effectively.

But in Europe, there are all sorts of legal constraints. Mostly because the Germans know what happens when you kick the can for too long.

The eurozone is beginning to butt up against its rules now. In completely bizarre ways.

The European Commission is threatening to sue the German government for a German court decision regarding contraventions of EU law by the ECB.

You might want to read that again to grasp just how bizarre it is…

It’s such a spectacularly garbled mess because the relationship between all of those institutions isn’t clear.

The European Commission can only sue national governments, not courts. But the German government doesn’t control the court. And the court merely interprets law. One piece of law it interpreted in its controversial recent decision was German constitutional law, which the EU Commission cannot change and even the German government would have a tough time to… The other piece of law was the European Commission’s, for which it is responsible, so there’s no point suing the German government, just change the law.

But can a German court really pull the rug out from underneath the ECB? Sort of, by tying its German arms behind its back. It’s not really clear what would actually happen next though.

The good news is that Covid-19 has hammered the entire eurozone, not just some of its members. That has slowed down the steady divergence in their economies – the underlying problem the euro creates.

It’s divergence during the good times and convergence during the bad…

But if the economic recovery only takes place in some nations, that’s going to be a huge problem. What if entire chunks of the eurozone are left behind as southern Italy was for the last 20 years?

It’s not like a falling exchange rate will save anyone any more, under the euro. Unless of course they leave the eurozone…

In coming years, countries like Spain and Italy won’t just miss having their own money which they could devalue. They’ll miss the deutschmark’s power to push tourists south too.

And that’s how I expect things to unfold in the end. The euro project can continue to go on for as long as people will put up with its consequences. But those are mounting. And people are realising it’s the currency that’s behind the problems.

It isn’t a German court which will slow down the europhiles. Nor the bankrupt banks or a sovereign debt crisis.

It’s ordinary voters and the politicians they elect which will make all the difference.

The only question is who will lead the charge and in what direction. Because it’s unlikely to be pretty…

At that point, you’ll wish you watched this now.

Nick Hubble
Editor, Southbank Investment Research

Category: Commodities

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