European leaders must return to the original reasons why the Union was formed is if they are to try and save the beleagured eurozone, writes Fiona MacRae of Alliance Trust
As politicians try desperately to avoid the train crash called the eurozone, the two main questions to arise are: how can they have got it so wrong? And, given their miserable record, will they still be able to rescue something credible from the wreckage? Unfortunately, even seasoned market participants cannot offer decisive answers. What we can try and do is put recent events into context, and assess whether there are any clear opportunities to exploit as events unfold.
Greece may be the Achilles heel of the eurozone experiment but the fundamental issues lie elsewhere. Just as a gunshot in Sarajavo lit simmering existing pan-European tension that erupted into the First World War, so the de facto declaration of insolvency by Greece provided the catalyst for the contagion events of the current sovereign debt crisis. We may be living in the aftershocks of a credit-fuelled bubble, but the eurozone is now experiencing the aftershocks of what can be called a ‘political bubble.’ In both cases, participants lost touch with reality.
The founding principles of the original Franco-German trade agreement were laudable. In the post-war years, economic integration within previous combatant countries was beneficial. The benefits of being in the club were such that soon there was a queue to join. This was given added impetus by the fall of the Berlin Wall and the break-up of the Soviet Union. Political expediency began to take the upper hand from this date as some politicians saw this as a means to extend control over eastern Europe and others saw it as a potential tool to control a reunified and potentially powerful reunited Germany. Reservations expressed by the then Bundesbank, among others, that the proposed monetary union would be unsustainable without a greater discipline and different political framework were brushed aside.
Defective at birth
So the eurozone was evidently defective at birth. There was still time to redress the situation in the oncoming decade, initially due to the economic benefit afforded by the weakness of the currency and then later by the economic growth powered by Germany and fuelled by global demand. But the politicians in non-core Europe were blinded by the cheaper credit afforded by association with Germany within the eurozone. Not only did they fail to address the structural flaws within the original agreement but they exacerbated them by believing they could party forever.
The crisis has highlighted the flaws in the European structure and the lingering prejudices within the European Community. So now the weaknesses have been laid bare and the edifice is crumbling, how do the participants shore it up?
Political unity
Firstly there has to be seen to be political unity and common political purpose. That is why the markets reacted so badly to Merkel’s fist-handed attempt to control bond markets. It raises fear of political disharmony, creates worries about further looming problems in the bankrupt German state banking system and raises the image of a King Canute trying to hold back the tide.
Secondly, there must be clarity over the recently announced intervention measures.
For the politicians, the bailout and ECB purchases of sovereign debt raises contagion risks considerably and represents the last throw of the dice. The rescue package buys them time – probably around two years on current funding requirements. For the transgressing countries of Southern Europe, the obstacles are clear. They need to use this period of respite to impose greater fiscal discipline and push through measures such as labour market reforms to increase the competitiveness of their economies. No one doubts how difficult this will be and the prospect of widespread social unrest is very real. Such steps are only the beginning. The next step must also be deeper structural reform.
Future challenges
The challenges ahead for the transgressing nations are clear. But the key question for the members of the eurozone out with the immediate ‘debt culprits’ is: how much are they willing to pay to keep the eurozone experiment alive? In this regard, the spotlight is firmly fixed on the largest member – Germany. The symbiotic nature of its relationship with its indebted southern neighbours is only now becoming clear. These southern nations may have used the lower interest-rate profile afforded by association with German monetary policy to overspend, but this low-cost ‘credit’ has been recycled into purchasing German manufacturing goods and to offset the low level of German consumption.
From a German economic perspective, to pay to go further down the eurozone integration route is sensible. But the German population is just waking up to the fact they have been sold a political lie. The ECB in its latest moves has abandoned any pretence of being a reincarnation of the Bundesbank and its anti-inflationary credentials now lie in tatters. The euro has plummeted as a result. Impartial observers may see this de facto devaluation and loose monetary stance as essential to maintain liquidity within the eurozone financial system and to boost economic growth through external exports. But the bulk of the German population heading towards retirement may view matters differently. They are a generation haunted by the fear of inflation and its potential devastating impact on their retirement savings. They have been instilled with the belief of the anti-inflationary credentials of the Bundesbank and the need for a strong currency. These beliefs have now been challenged. The ineptitude of the politicians during this crisis will have augmented their unease over the euro experiment.
Rethinking the blueprint
The founding principles of the European Community were sound. But over time the whole project has increasingly become a political playground for career politicians. European citizens have felt increasingly disengaged and sceptical about the whole structure. The recent crisis has shown power still lies with the heads of government at the largest nation states such as Germany and France. The costly edifices of the eurozone have been shown to be completely irrelevant. Within the rescue package there is already a commitment to strengthen economic governance, surveillance and policy coordination within the eurozone. This may be unpalatable to many politicians at a nation state level. But for electorates to accept the public spending cuts in a sustainable way, and for the eurozone to survive, the politicians must rethink the blueprint of the eurozone and the EU, engage the European electorate and make the institutions less bureaucratic and more effective.
The challenges are therefore clear but equally so are the measures European governments need to take. Whether they succeed is still open to doubt. European markets will likely demand a discount for the uncertain background for some time. But valuations reflect the fact markets are currently discounting the risks and not assessing the opportunities. Many companies quoted in Europe have only a limited exposure to their domestic economies. The weaker euro will help to ease pain throughout the system, and if governments do convince markets with their actions, many European financials have significant upside from current valuation levels. Indeed, while European politicians are facing their day of reckoning, for value investors the current situation offers a happy hunting ground.
Fiona MacRae, fund manager, Alliance Trust European Equity fund
