The Euro: A Train That’s Running Out of Track

In the late 1980s, a group of European central bank governors was asked by the Bank of International Settlements (BIS) to serve on a committee to study the future economic and monetary union of Europe. This committee would be named after its chairman, Jacques Delors. It involved 17 members, including the president of the Bundesbank, the governor of the Bank of England, and the BIS General Manager at the time, Alexandre Lamfalussy.

At the BIS’s headquarters in Basel, Switzerland, the Delors Committee was tasked with determining the technical aspects of how European economic and monetary unity could be achieved. It was there, behind closed doors, that these central bankers would concoct a plan to create an economic union between European countries, tied to one currency, and run by one transnational central bank. The Delors Committee released its report to the international community in 1989, setting in motion the creation of the euro.

The report was initially applauded and led to an additional 15 reports from the BIS over the next two years, all of which outlined the gradual process of how to bring European nations under one monetary policy in order to create price stability, improve trade, and reduce political conflict. These reports eventually led to the signing of the Maastricht Treaty in 1992 by twelve countries that formally established the European Union and introduced a new central bank system that planned to create one single European currency.

The Maastricht Treaty also resulted in the creation of a new institution called the European Monetary Institute (EMI). This institution would be led by the now former BIS General Manager Alexandre Lamfalussy, who was tasked with constructing the euro along with a new transnational central bank that would remove governments from monetary policymaking. This bank would be independent of political control, would oversee monetary policy for all the member countries, and would be charged with ensuring price stability throughout the region.

The EMI ultimately would serve as a precursor to the European Central Bank (ECB). As the EMI developed the regulations and policies around the ECB and the euro, questions began to arise about how a transnational currency would work when each participating country had differing fiscal policies, economic structures, and cultures.

One such skeptic of the euro was the famed economist Milton Friedman who said,

Harvard Economist and President of the National Bureau of Economic Research, Martin Feldstein also chimed in on the drawbacks a shared single currency would have on European economies.

The main critique highlighted by both men was that individual countries require independent monetary policy to respond to exogenous shocks to their unique economies. By giving up their monetary sovereignty to the ECB, governments would be unable to use flexible interest rates as a tool to combat economic shocks. In addition, because governments retained the rights to their own fiscal and tax policies, this created a dynamic where each country’s spending decisions would influence the other members of the European Union. In other words, member countries were always at odds with one another and had no mechanisms for dealing with a country if its sovereign debt came under stress. These flaws were inherent in the euro’s design from the start.

However, the concerns from economists and central bankers were widely ignored by the EMI. This is partly because, at its heart, the move to the euro was not an economic decision but a political one. European leaders at the time felt that a unified Europe could challenge U.S. dollar hegemony, improve global trade, and reduce political tensions between European nations stemming from nationalist tendencies that had led to devastating world wars in the past.

This reality was echoed by Rupert Pennant-Rea, deputy governor for the Bank of England in the 1990s when he stated in an interview,

Therefore, the warnings of many prominent economists and central bankers fell on deaf ears, and in June 1998, over 4 years after Alexandre Lamfalussy had established the EMI, the European Central Bank was founded, and seven months later, on January 1st, 1999, the euro was launched.

The change from 11 national currencies to one common euro currency was a monumental moment in economic history and European integration. The first decade of the euro was marked by growth, price stability, and expansion. EU member countries expanded from 11 to 27 member countries by 2007. Today, 19 of European countries use the euro as their national currency.

To become a member of the EU, there are specific fiscal criteria that a country must meet. The Stability and Growth Pact, effected in 1999, requires that all EU member countries must keep their debt-to-GDP under 60%. This pact was put in place to prevent excessive deficit spending. The goal was to avoid the scenario where more fiscally responsible nations in the EU would have to bail out more spendthrift nations. Therefore, to deter excessive spending and reduce the risk of currency devaluation, rules were put in place where if a member country exceeded this 60% debt-to-GDP limit, they would be subject to a fine of up to 0.5% GDP and be required to develop an economic blueprint on actions they would take to improve their balance sheet.

Public debt, as measured by debt-to-GDP, was not much of a concern for the EU in the 2000s, but it did start to accumulate throughout the decade. More importantly, it started to grow disproportionately in specific member countries of the EU compared to other more fiscally conservative member countries like Germany and France.

The chart below highlights how public debt grew differently in each member country throughout the period from 1982-2011.

First, notice how Greece and Italy both had debt-to-GDP above the 60% threshold since the late 1980s. They never even met the EU’s sustainability criteria. Second, note how the debt-to-GDP of peripheral countries like Greece, Portugal, Spain, Italy, and Ireland (better known by their acronym the PIIGS) grew at a much more rapid rate compared to France and Germany around the Global Financial Crisis of 2008. Although the 2000s were a period of good economic growth, EU expansion, and low inflation, it also marked a period where fiscal vulnerabilities were building under the surface.

In the first decade of the union, the PIIGS experienced credit booms leading to high growth rates and elevated inflation. This reduced their economic competitiveness and led to large current account deficits that had to be financed through foreign borrowing. This credit boom mainly occurred because the government debt of the PIIGS was valued near the same price as Germany, reducing interest rate spreads between the nations, and persuading politicians that the monetary union was succeeding above expectations. This led to a lot of complacency and premature self-congratulations from euro proponents.

The PIIGS took full advantage of this financial market mispricing and borrowed a lot of money at interest rates normally given to Germany despite large differences in their risk profiles and economies. Despite PIIGS deficits ballooning, European governments did not act to push any fiscal reforms to bolster the long-term health of the monetary union because things were going so well on the surface. Even though it made little sense why the interest rate applied to borrowing countries with large deficits was about equal to the most solvent country in the EU, Germany, foreign investors still bought the story, and purchased these PIIGS bonds hand over fist without fully understanding the risks involved.

All of these vulnerabilities were laid bare during the Global Financial Crisis. With the European banking system struggling with massive loan losses from the subprime mortgage crisis, and liquidity drying up in the markets, this would set the stage for a European sovereign debt crisis, specifically in countries with high debt-to-GDP ratios, like PIIGS.

The European debt crisis began in 2009 when Greece reported a deficit of 12.7% of GDP, which was more than double what was expected at the time. In response, to avoid a Greek default, government leaders, central banks, and the IMF established a temporary rescue fund worth $1 trillion for struggling Eurozone economies called the European Financial Stability Facility (EFSF). This was a very controversial action at the time because many felt the EFSF infringed on the “no-bail-out” clause of the Maastricht Treaty which prohibits states from assuming responsibility for each others’ debts.

The EFSF allowed the EU to raise funds through the issuance of EFSF bonds and then loan those same funds to struggling nations, like Greece, to prevent default or further sovereign debt contagion from spreading throughout the Eurozone. Greece was bailed out in 2010 to the tune of $146 billion. However, to the chagrin of the ECB, this was not successful at stopping the credit contagion from spreading. From 2010-2012, Portugal, Ireland, Spain, and Greece (for a second time) all required bailouts through the EFSF.

Notice below how the bond spreads between German bonds and the PIIGS stayed nearly flat before 2009. However, once the Greek crisis began, the bond yields of all the PIIGS compared to German yields began to widen before exploding higher in 2012 even after the EFSF bailouts occurred.

Since all of these countries shared a common currency, the difference in bond yields from the more stable German bond can be thought of as the perceived risk of credit default for these countries. In other words, investors were worried about slowing growth and these sovereigns’ abilities to service their debt — thus the higher interest rates. This made it harder for these countries to roll over their short-term debt and created a feedback loop of negative investor sentiment leading to higher interest rates which increased the likelihood of default.

Despite the bailouts facilitated by the EFSF, the PIIGS’s interest rates remained stubbornly high in 2012. Greece was a relatively small country, so its default was not too much of a concern for the ECB in terms of the overall health of the Eurozone. What kept them up at night was the risk of credit contagion spreading to larger Eurozone countries like Spain and Italy, which could be catastrophic. This risk of contagion is what ultimately led to the moment when ECB President, Mario Draghi, famously declared that the ECB would continue to assist struggling Eurozone nations to avoid the collapse of the European monetary union.

In the speech at the Global Investment Conference in London, Draghi famously vowed,

Draghi extended the EFSF in the form of a new, permanent bailout fund called the European Stability Mechanism, where distressed countries could acquire cheap loans from the EU, and also established a program where the ECB would purchase an unlimited amount of bonds on the secondary market of distressed eurozone members called Outright Monetary Transactions (OMT). An important caveat is OMT would be “sterilized” — that is, offset by removing equivalent liquidity from other parts of the euro system to counter inflationary risks. This is an important distinction from Quantitative Easing (QE), which prints money to buy bonds to inject new liquidity into the system to stimulate economic activity.

The mere announcement of this unlimited bond-buying program immediately quelled investors' fears, and the bond yields of the PIIGS began to fall even though the OMT ended up never being used by the ECB.

One can visualize this change in investor sentiment by looking at the Credit Default Swaps (CDS) of these sovereign bonds. CDS can be thought of as insurance investors can buy to protect themselves in the event of a sovereign default. Notice how the CDS of the member countries that were at risk of credit contagion dropped meaningfully after Draghi’s speech.

After the speech, the euro steadily rose as investor sentiment improved now that they knew the ECB would always be the buyer of last resort for sovereign debt. However this may have buoyed the short-term outlook, but it did nothing to improve the long-term growth and inflation picture of the Eurozone at the time. A nation with its own sovereign currency can handle such situations by devaluing its currency to make its exports cheaper and more competitive and encourage foreign investment. But because these Eurozone countries shared one common currency, they did not have this luxury. It was up to the ECB to find a way.

Up to this point, all of these emergency facilities only served as bandaids. What the ECB really needed was to find a way to spur a strong economic recovery in these struggling, overly-indebted economies. To accomplish this, Draghi cut the ECB deposit interest rate and eventually dropped it below zero in 2014.

If you look at the chart above, you’ll notice that the ECB was raising interest rates before Draghi was elected. That’s because Eurozone inflation started to rise above 2% as the recovery picked up in stronger Eurozone states, like Germany.

This led to the ECB raising interest rates right as the PIIGS were still mired in deep recession. This is exactly what economists like Milton Friedman had warned about when the euro was first designed. The differing economies and balance sheets of its Eurozone countries posed enormous challenges for the ECB’s ability to effectively implement monetary policy. If they raised rates to combat inflation, it could cause the PIIGS economies to collapse. If they didn’t raise rates, the euro would lose purchasing power for all of its member countries.

Despite this, once Draghi took over, he immediately cut rates for he feared deflation was more of a threat to the euro’s survival than inflation. The same thought process revolved around QE. Unlike the Federal Reserve, the ECB was hesitant to perform outright QE because they feared it would lead to inflation. But as the growth picture continued to deteriorate, the ECB eventually became convinced that the euro would not survive deflation and its third recession in a decade. Therefore, in 2015, Draghi implemented QE via the ECB’s Asset Purchase Programe (APP) and began injecting billions of dollars of liquidity into the Eurozone financial system every month, expanding the ECB’s balance sheet in the process.

The ECB started its AAP programs right as the Federal Reserve eased its QE programs and began to raise interest rates in 2015. Both of these factors, along with continued fear around Greece’s economic recovery, led to the euro losing purchasing power against the dollar rapidly throughout 2014-2015.

Despite their concerns, the chart below shows that inflation did not rise significantly as the ECB expected, and the euro eventually stabilized above US dollar parity.

In the end, this was a Goldilocks outcome for Mario Draghi and the ECB. By implementing negative interest rates and the ECB’s Asset Purchase Programe (QE), they prevented a deflationary crisis from occurring and kept the European monetary union together during the European Debt Crisis. They did this all without crashing the euro’s purchasing power or causing a major Eurozone sovereign default from occurring.

As a result, Draghi was given the moniker “Super Mario” and was hailed as being the man responsible for “saving the euro.” But as we’ll soon see, Super Mario did nothing to fix the underlying issues that plague the euro system to this day. He was merely successful at kicking the can down the road until the next crisis.

The reason why I think it’s important to understand the European Debt Crisis in the early 2010s is that, in many ways, the European Union is still suffering the consequences of those events. There are many historical parallels between then and the current predicament the ECB faces. By studying the past and understanding the history of the euro, perhaps we can better estimate what actions the ECB will take to tackle the challenges they face today.

Unfortunately for Super Mario, everything did not turn out how he thought it would for the EU. Many economies in the Eurozone saw a lost decade of economic growth in the 2010s due to a myriad of factors including stubbornly high unemployment, weak banking systems, large debt burdens, and harsh austerity programs attached to the bailout funds received during the European Debt Crisis.

It took 6 years for the Eurozone to return to its 2008 GDP level, and some members did even worse: Spain and Portugal took almost a decade, and Italy and Greece have yet to get back to their pre-Global Financial Crisis growth levels. Eurozone countries clearly were lagging other countries when it came to their economic growth in the 2010s, as shown in the chart below.

This below-trend economic growth occurred despite ultra-accommodative monetary policy from the ECB throughout the decade. The ECB maintained its benchmark interest rate at negative levels from 2014 on and, outside a short period from 2018-2019, continued its QE programs the entire time.

In fact, in 2019, before the COVID-19 pandemic even started, the ECB was still cutting interest rates further into negative territory due to low economic growth. Once the lockdowns began, the ECB went into hyperdrive. They introduced a new Pandemic Emergency Purchase Programe (PEPP), which was an extension of the Asset Purchase Programe that began during the European Debt Crisis. The total amount of government and corporate bonds the ECB was allowed to purchase through this new QE program amounted to €1.85 trillion!

Dr. Edward Yardeni of Yardeni Research highlights below the explosion of the ECB’s balance sheet since the introduction of its PEPP program.

The ECB used the same playbook that Mario Draghi used during the European Debt Crisis, except this time, interest rates were already negative. The ECB had no room to cut rates further. In addition, there are other important differences between the economic backdrop of the Eurozone today compared to then.

The biggest difference is that CPI inflation has soared to 8.9% YoY in July, its highest level ever since the euro’s creation. This is in part due to sky-high food and energy prices resulting from major geopolitical events like the Russian-Ukraine War.

This has forced the ECB into a corner. Its mandate is price stability and traditionally, these high inflation prints would require them to increase interest rates. But an additional difference between now and the early 2010s, is that the debt-to-GDP levels of all Eurozone countries have risen significantly. Once again, Southern European countries like Italy, Greece, and Spain have by far the largest debt-to-GDP levels, but now even traditionally fiscally conservative members like Germany also have debt- to-GDP ratios that are higher than the 60% level that was agreed upon in the Stability and Growth Pact.

The Stability and Growth Pact was suspended in May 2020 as an emergency pandemic measure, and it is unclear when these fiscal rules will be reinstated. What is clear, is these debt levels are unsustainable even by the European Union’s own standards and leave these economies highly sensitive to any increase in interest rate hikes. If the ECB tries to fight inflation, they risk causing a sovereign debt crisis.

Similar to the European Debt Crisis, the ECB was slow to react to the changing conditions compared to other central banks and was still performing QE and maintaining its interest rates when the Federal Reserve began increasing rates aggressively and began Quantitative Tightening. This dynamic has resulted in serious pressure on the euro. It recently hit its lowest level compared to the dollar and briefly hit dollar parity for the first time in 20 years. The euro is currently down 13.89% against the dollar over the last year.

In response to these troubling currency developments, in its June meeting, the ECB announced that it would stop its bond-buying programs and raise interest rates for the first time in 11 years. The ECB’s shift to attack inflation instead of supporting its economy raised concerns about the impact that higher interest rates would have on heavily indebted governments, most notably Italy. Just like the PIIGS in the European Debt Crisis, almost immediately from that news, the spreads between these bonds compared to German yields began to rise.

This gulf in the bond yields between the region’s strongest and weakest economies led to an emergency ECB meeting where a new “anti-fragmentation tool” was announced. In addition, the ECB remodeled its PEPP program so it can use reinvestments of maturing debt more flexibly. Said differently, they are taking maturing debt from stronger economies, like Germany, and using the funds to buy the bonds of weaker economies, like Italy.

In an attempt to keep these highly indebted nations’ borrowing costs low, since June, the ECB has injected €17bn into Italian, Spanish and Greek markets while allowing its portfolio of German, Dutch and French debt to fall by €18bn.

These actions merely shuffle euros around from stronger economies to weaker ones in order to shield the weaker economies from the negative effects of rising interest rates. It is akin to the ECB trying to plug leaking holes in a dam. It is obviously an unsustainable solution to the long-term problems the ECB faces.

In July, the ECB went ahead with a 0.50% interest rate hike moving its interest rate off negative for the first time since 2014. It also shared more details about its vague “anti-fragmentation tool” which was formally named the Transmission Protection Instrument (TPI). The tool allows the ECB to buy any country’s bonds as they see fit at an unlimited scale. Many saw this as ECB President, Christine Lagarde’s “Draghi moment.” Back when Draghi announced OMT and its unlimited nature during the European Debt Crisis, just the mere announcement of OMT was enough to quell fears in the markets. Many believe the ECB hopes just the existence of the TPI will have a similar effect on bond markets.

In an interview, ECB board member Isabel Schnabel gave her best Draghi impression when she said in a speech,

To the ECB’s disappointment, even with the announcement of the TPI, the spreads between Italian and German bonds have decreased only slightly, and the cost of insuring against an Italian default (CDS price) still remains high, indicating that investors are not yet sold on this new unlimited bond-buying instrument. This comes as Moody’s recently cut their outlook for Italy from neutral to negative, citing increased political risks, sluggish growth, inflation, and higher funding costs as the main reasons.

Despite all of the ECB’s tools and efforts, the risks around Italy and other peripheral Eurozone countries continue to rise, all while record-high inflation continues to ravage every country in the European Union. The ECB currently finds itself in a horrible conundrum. Only time will tell if they will be able to navigate these challenging times and hold this fragile European Union together or if, in fact, we are witnessing the gradual collapse of a monetary experiment gone terribly wrong.

The similarities between the European Debt Crisis and the current Euro Crisis are uncanny because both reveal the same issues of a monetary union that was flawed from the start. It is impossible to have a stable monetary union when it consists of countries with differing fiscal policies, economies, and cultures. Eventually, especially in times of crisis, nations abandon transnational monetary rules for their own government’s self-interests.

It is safe to say all the problems that led to the European Debt Crisis were only masked over by central bank monetary policy, bailouts, and massive amounts of fiscal stimulus. It should not surprise anyone to see the same structural problems of the euro remerge as the ECB attempts to tighten monetary policy and stop its bond-buying programs in order to reign in inflation. The euro was flawed economically from the get-go. These flaws have caused severe problems in the past, and now they are painfully rearing their heads again.

Bitcoin’s main competition as money is fiat currencies. When a major fiat currency comes under pressure like this, it’s ultimately good for Bitcoin’s long-term adoption. The euro is the world’s second-largest currency by trading volume and is the second-largest holding of central bank foreign exchange reserves. The path of least resistance for the ECB appears to be that it will sacrifice the euro’s value in order to prevent a string of sovereign defaults from fracturing the European Union. We are currently watching one of the largest fiat currencies in the world devalue at a rapid pace, and all signs are pointing to this dynamic continuing in the future.

The question becomes, what will the ECB do next? The ECB is currently trying to ride two horses at once. It wants to raise interest rates to bring down inflation, but it’s also attempting to continue with its bond-buying programs to keep the borrowing costs of its weaker economies from rising and causing a potential credit contagion event. These two policy choices are directly at odds with one another.

Italy is the third largest economy in the European Union. This is no Greece. If Italy were to default, it would cataclysmic for the European Union. It’s too big to fail. Therefore, there’s an increased probability that a bailout similar to the ones we witnessed in the European Debt Crisis is on the horizon. In other words, more money printing, more bond-buying, more devaluation, and more economic stagnation for the Eurozone region.

A recent interview with ECB President Christine Lagarde posed a question to her as she was shown a chart of the ECB’s balance sheet, “This is going over €8 trillion now, don’t we see a giant bubble on your balance sheet with the euro, and isn’t this graph nerve-wracking?…How do we get it back down?”

Her answer, as she nervously laughed and shifted in her seat, “It will come…In due course…it will come.”

Indeed, we shall see, President Lagarde, we shall see.