Week after week, it feels like the Eurozone is inching closer to the brink. Of course, there is still a lot of denial. We are made to believe that all is well in the best of all possible worlds.
But the danger of fragmentation and dislocation within the Euroarea is getting even more present and clear. Yes the euro zone is in existential danger.
The danger threatens our economy, our savings. So we have to prepare. We have to be ready because this will have global consequences.
The powerful hot winds of disruption are blowing from many directions;
- From France where inflation keeps creeping up and consumer confidence is collapsing.
- From Italy where a political crisis paves the way for totally uncertain elections in the Fall.
- From Germany which is hit from all parts with inflation, energy supplies and with increased doubts regarding its role within the Euroarea.
- From the European Central Bank with a decaying credibility that will limit is ability to have an impact and precisely generate this new crisis in the eurozone, perhaps even destroy the zone?
Let’s start with the European Central Bank. It just increased its key interest rate (the refi rate, the bank refinancing rate) from 0% to 0.5%. That’s good but it’s time for the ECB to smell the coffee. That rate hike alone, is not going to do anything. The ECB’s target is 2% for inflation, yet the actual inflation in June was at 8.6%, an all-time high which did not happen overnight.
So, if the ECB is really intent to fight inflation, it would have to go with another series of 800 basis points at least. So far, this was barely an olive from the starters menu.
And yes, that inflation did not pop up just like that, like thunder in a blue sky.
We have been announcing this rising inflation for months and months and seen it creep up higher and higher every single month. Meanwhile, the European Central Bank was doing nothing. Just watching and calling it “transitory”, that magic word to exonerate itself from its own responsibility.
So, that rate hike is encouraging because it shows that the ECB just removed its rose colored glasses. But by waiting for so long to step up to the plate, it has also eroded its credibility. You see, what makes a Central Bank efficient has nothing to do just with what it does, but with how it does it. Moving rates higher or lower is a monetary motion that has a certain importance, but that alone is not what makes the move potent. It’s also the style and gusto with which it is performed. For those of us who are old enough to remember, we knew that the Bundesbank had a certain style when it delivered a monetary move. Probably 80% of the impact of that move came from the style with which it was doing it. And that’s the aura and style the ECB is missing. It’s trying to act as if it is the Bundesbank but it’s not the Bundesbank…
So the argument used so far is the following; Euro rates have to be raised to somewhat follow the FED and reduce the interest rate differential between the United States and Europe.
In theory, that’s true. Ideally, with that rate hike, the euro should have appreciated a lot more. But that’s not what happened. The Euro did bounce back but just a little bit up. We are barely at $1.02 for the Euro. It hardly moved. And that alone is testimony to that eroding credibility for the ECB.
That alone is very concerning.
And why ?
First, because the ECB waited for so long.
And second, because this rise in interest rates couldn’t come at a worst time than the one we are living now. What is crucial to understand is that normally a central bank must anticipate what is going to happen. When in 2021 we saw inflation looming on the horizon, a forward-looking and vigilant ECB should have stopped printing money, or even raised interest rates a little bit. This would have built a necessary cushion, which would have made it possible today to reignite the economic engine.
But, that’s not what happened.
Not only did the ECB appear like it was sleeping at the steering-wheel all the time by losing control over inflation, but now, in order to correct that impression, the ECB is now raising rates precisely when the euro zone is plunging into recession. That whole mishmash alone is enough to seriously harm the credibility of the European Central Bank.
Add to that mixture the most recent economic indicators. The latest leading indicators for the Euro zone, the so-called purchasing managers’ indicators in industry, in services, all sectors combined really stands on the brink between recession and growth.
But we are probably already in recession.
And that’s the time the ECB chooses to wake up and hike rates…
….. Bravo !!!
We are definitely in the process of falling back into recession and, moreover, we have also seen this for several months in the household confidence index.
With inflation soaring beyond reason, from then on, households have no margin to continue consuming. So household confidence is collapsing. In France, the figures for July are at the lowest since the 2009 recession. It is even worse than the 2013 crisis with the Greek crisis, or even the coronavirus.
So this is what is happening today in the Eurozone.
And unfortunately we did not anticipate this, and above all we used all our ammunition during the coronavirus pandemic. We no longer have the means to restart the machine and we see that of course everywhere, especially in France.
The latest indicators in the industry are therefore back below 50 for France. In services, it is still resisting thanks to tourism. The GDP has already seen a decline in the first quarter of 2022. Two consecutive quarters of decline in GDP, would qualify the business cycle as a recession. And France is directly under that threat.
That recession is certainly already there, here in France, and in the eurozone as a whole. And the margins to restart the engine have evaporated.
Everywhere in Europe, we have public debts which are still at stratospheric levels, as in Italy. In Italy, a political crisis has now been added to the mix with Mario Draghi’s resignation. We are therefore going to have new elections next fall. Public debts are indeed extremely dangerous in certain countries, such as Italy and France.
In Germany, it is at 70% public debt of GDP. If we look at the euro zone, it’s around 95% on average, below 100%. And then after, obviously you have Greece and Italy. Greece is at 190%, Italy at more than 150%. In Portugal, Spain and of course France, we are at about 115% of GDP in public debt and soon 120% certainly.
Take a look at the Italian GDP excluding inflation from 1999 to 2021, and you’ll notice that the level of the Italian GDP is at the level we had in 2000. Incredible, isn’t it ? Because it means that Italy wasted two decades. For Greece it is even worse, because we are at minus 27%. The Greek GDP today that is equivalent to the level we had in 1998.
So this crisis is societal. It threatens political stability as a whole. There are temptations on slightly anti-system politicians and if they come to power in the Fall in Italy, that could explode the EURO zone.
As a result, Italian interest rates have risen very sharply. The rate spread between Italy and Germany is at extremely high levels with a spread of 240 basis points.
Until now, Greek yields were always above the Italian yields. Guess what? Recently, we witnessed something quite incredible. Something historical; the Italian yield exceeded the Greek yield, meaning that markets have less confidence in Italy and more in Greece.
In Germany, the press observes all this and is absolutely not satisfied with what is happening. Beyond Italy, the criticism of the German press is now openly directed at the policy of the European Central Bank, even comparing the latter to how Turkey is handling the Turkish Lira.
We are no longer in the same situation as the one we had with Angela Merkel. Up to now, the Germans, notably thanks to the leadership of Mrs. Merkel, have always been able to rely on their credibility. Today, we are no longer on the same wavelength. When Germany was doing well, it could actually afford to accept few slippages and procrastination here and there within the EURO zone.
This time, it’s very different. Because, at the moment, in Germany things are going badly. The latest leading indicators for purchasing managers in industry and services are below the 50 mark. Germany is therefore plunging back into recession. If we look at the business outlook, we are at their lowest since April 2020 in the midst of a pandemic. So there too, that announces a collapse of the German GDP. And so, therein lies the problem. Now even the Germans are running external deficits. Their economy is bad and they are no longer willing to pay for everyone. Overall today Germany no longer has the means to support this euro zone and therefore that is what is extremely dangerous.
There is even a new echo called GERXIT, the risk that Germany itself decides to exit the Euro. That too cannot be excluded.
We therefore find ourselves on the verge of a new financial crisis of the 2008 type, but much more powerful and way more systemic. Because this time, it is not about a bank or a too big to fail institution falling apart. This time, we are dealing with sovereign states.
So what could happen?
We cannot exclude the creation of a new euro zone, made of several groups of countries. Or obviously we could also have everyone revert back to their older currency and, there obviously imagine the chaos that it would represent.
But at the same time, in the midst of this shambles and all this inflation, the great danger is that states will obviously no longer be able to finance themselves so easily.
States could then revert to schemes coming from a past that we thought we would never see anymore;
- They could for example raise taxes especially on wealth and savings accounts. In fact, there was an IMF recommendation in January 2021 advising States to draw on the savings and wealth of citizens.
- And then as this prospect will cause fears on the part of savers, it is also not impossible that another danger will point its nose, which is that of a gradual closing of the borders with of course customs duties.
- Exchange controls could also come back. For those of us old enough, we knew what they looked like. Investment and capital flows could be subject to many more restrictions and controls. It would be a throwback to the 80s. A return to the past but back to the future too. States and regulatory agencies have indeed all the technology and algorithms they need to implement these restrictions a lot more easily and efficiently than in the 80’s.
So don’t think that this seems delusional and excessive. It is a lot more possible and probable than it appears.
Clearly, we are on the cusp of a new era. That’s what I wanted to share with you today. Let me know if you have questions and feel free to comment.