History of the European Union
The origins of the European Union can be traced to the period after WW2, with the main driver being the achievement and preservation of peace. The post-war period was particularly difficult – with Europe being badly damaged after two world wars – and as a result, the vision of a European Union was born as a natural step in the aftermath.
After the fall of the Berlin wall in 1989, work began on integrating European countries in terms of four ‘freedoms’: movement of goods, services, people and money. This integration would bring down the traditional boundaries between countries and create a continent-wide area of seamlessly integrated markets. The rationale and vision for creating such a union were undoubtedly justified and ambitious.
The Maastricht treaty was finally signed in 1992 by the founding member-states. As it currently stands, the EU is a political union of 28 member-states, having started in 1998 with 11 member-states meeting a number of euro convergence criteria:
- Budget Deficit
- Debt-To-GDP ratio
- Exchange rate stability
- Long-term interest rates
It is also a monetary union of 19 member-states, having started on the 1st January 1999 and with physical coins & notes being introduced on the 1st January 2002. It should be noted that there are more countries scheduled to be added to the EU in the upcoming years.
The motivation for joining the European Union has always been very strong, with many obvious benefits for member-states. EU-funded subsidies provide a great incentive for weaker countries to join the union, as they can be used for infrastructure development and other projects. As a result, there have been some serious questions regarding the validity of the criteria for certain countries prior to joining (the most obvious one being the Budget Deficit and Debt-To-GDP ratio of Greece).
Current Structure of the European Union
Twenty years after its inception, the European Union has morphed into something much heavier and more complex than originally envisaged or possibly intended. Below is a non-exhaustive list of some of the major functions and issues of the EU:
- The European Central Bank (ECB) sets the monetary policy.
- The Eurogroup (represented by countries’ finance ministers) makes political decisions regarding the eurozone and the euro.
- The European Union Court of Justice is the chief judicial authority of the EU and oversees the uniform application and interpretation of European Union law.
- There are specific EU Departments for the Environment, Communications, Competition, Data Protection, Migration, Trade, Energy and many others.
- There is fiscal integration, where there is a peer review of each country’s national budgets, although a particular country cannot be forced to apply criteria dictated by other countries.
- Technically there is no provision for a country to exit the Eurozone (it is ‘irreversible and irrevocable’). However, in 2009, an ECB study argued that expulsion remains conceivable.
- The European Union has developed complex policies & regulation on things like agriculture, fisheries, livestock, manufacturing, financial services etc.
- There is increased talk (most recently by French PM Macron) about forming a common European Union army, which has been met with broad criticism and concern.
Current Problems Faced by the European Union
The biggest problem within the EU is probably the vast divide between the north and south countries, in terms of mentality, productivity, and fiscal prudence. This is a structural problem that existed from day one, but which hadn’t surfaced while the Eurozone was still nascent and growing. It was always going to be a herculean task to integrate such diverse countries within one economic and currency union. The divergence in productivity between countries like Germany and Greece is huge, as is their attitude towards budget balance and public sector operation. This translates in persistent and considerable deficits in southern countries, while northern countries manage to run a much tighter ship.
This is a problem that already existed for many decades, and which traditionally has been overcome by weak countries using their exchange rates. Countries like Greece, Portugal, and Italy would devalue their currencies every decade or so, issue more debt and kick the can further along. With interest rates in their sole control, southern countries could effectively inflate their debt away, slowly reducing the purchasing power of their currency (and their citizens).
With the European Union as it currently stands, this option no longer exists for individual countries. They all now have the same currency – the Euro – and their ability (and cost) of issuing debt is dictated solely by the markets themselves. As we have seen with Greece’s case, when a country is in distress it becomes practically impossible to access the debt markets for funding, and so the country needs to be bailed-out (or indeed bailed-in by its own depositors). In contrast to the United States of America, there is no possibility of free transfer of funds from surplus states to deficit states. This means that countries like Greece, Portugal, and Italy are left to their own devices when it comes to making ends meet.
It’s also very difficult to have one single interest rate strategy for a wide range of countries with very different characteristics. The ECB obviously tries the best it can, given the constraints, but it’s a particularly difficult task to follow an interest rate path that satisfies member states which might be in an expansionary phase and others which are in recession.
The net result of these structural differences between European countries – and something that was clearly evident in the recent European crisis – is that downturns are much more severe in southern countries. In the past few years, Germany only experienced a mild slowdown, while southern economies were crippled. Youth unemployment, one of the most important forward-looking indicators, plummeted in countries like Portugal (20%) and Greece (>50%). Unfunded liabilities have rocketed higher, making them a ticking time-bomb. Low GDP per capita and extremely low wages were a natural result, as the countries faltered.
So, what’s the solution to this conundrum? Is there a solution?
Yes, there is – if governments engage in a fiscally prudent manner, after the initial period of difficulty, the resulting surpluses should bolster their economies and bring stability & optimism. Where there are stability and sound fundamentals, investment (both internal and external) follows. Unemployment drops and productivity rises, in a virtuous circle.
The Italian government’s approach to the current situation, however, is quite different. Their rhetoric is strongly on the populist side, promising a lot but unable to demonstrate how it will be executed or funded. They insist on a higher than normal budget deficit, hoping that this would kick-start the Italian economy and be the spark that initiates an economic recovery. The EU wants to see a deficit well below 2%, but the Italian government is pushing for 2.4% (and perhaps more). The ECB currently sees the Italian budget deficit reaching 3% by 2020, a fact that’s very worrying indeed.
But can the Italian government just choose an arbitrary large deficit level in hope that this will help them reach their goals? The answer is no because deficits need to be funded. Future unfunded liabilities also need to be serviced. As Italy no longer has the option of printing its own currency, it will have to access the debt markets, running the same risks that Greece did in 2012. If its loose fiscal policy doesn’t yield quick results, chances are that it will face the same financial distress as Greece did.
Finally, as many politicians are quick to point out, ‘Italy is not Greece’. That statement is correct! Italy is a much bigger country than Greece, in every way. Their total government debt is approaching 2.5 trillion Euros, and that’s not a number that can be bailed-out like Greece’s was. If the Italian situation gets out of hand and confidence drops dramatically, this problem could be like a nuclear bomb to the foundations of the Euro itself.
It’s not all doom and gloom, however. If the Italian government manages to successfully bring the country back into a solid growth trajectory, that would be a great boost for the country and the Eurozone as a whole. The next crisis could well end up bolstering the European Union and pushing the Eurozone countries towards a more integrated and constructive future.
Looking at a long-term chart of the Euro Index (EXY), we can see that it’s been in a broad downward channel since the 2008 Global Financial Crisis. We are currently on the confluence of the neckline of an apparent head & shoulders pattern and the 200WMA. The Euro now has to make a big decision and the Italian developments will no doubt play a big role in this.
This article was written by Forex Analytix
This article was originally posted on FX Empire
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