Europe's Crumple Zone

Alphen, Netherlands, 26 April.  London in the spring sunshine feels like an episode of the X Files.  A strange bright, warm object appears in a rare clear, blue sky of which no-one can make sense.  On Wednesday I had the privilege of providing evidence to the House of Commons Defence Select Committee at its first meeting to consider the 2015 British Strategic Security and Defence Review alongside Lord Hennessy and Major-General Mungo Melvin.  Those of you sad enough to wish to see Friendly-Clinch with Battle Ensigns flying can go to http://www.parliament.tv Perhaps the most important contribution I made was to suggest to collected British politicians of all shades that whatever reforms are made to Britain’s strategic security and defence structures little will change unless the political class imposes effective oversight. 

 

However, Britain’s strategic future is not the purpose of this missive.  Rather it is a comment made by an old university friend over lunch in the City, London’s financial powerhouse.  He suggested that the Eurozone crisis was still in what he called the “crumple zone”, i.e. that part of the car designed to implode on impact to protect the occupants.  In other words the crash is still happening.

This week a six-page European Commission memorandum was leaked which revealed concerns that a Financial Transaction Tax (FTT) would not only drive up costs of government borrowing across Europe but damage the all-important bond markets.  As the FTT is an ever-so-thinly-veiled attempt to get the British to pay for the failed political experiment that is the Euro it is causing both alarm and irritation in London.  Even if Britain excuses itself from this tax firms based in Britain would be badly affected by it and one of the first laws of economics is that there is no such thing as a free tax.  So why are they doing it?

One has only to look at the figures to see why those few Eurozone countries paying for the Eurozone disaster want to spread the costs as widely as possible.  The Eurozone faces a perfect storm that will take at least a decade of pain to resolve.  It is a storm caused by the coming together of fragile banks in need of bail outs and governments that cannot pay for themselves due to debt interest and deficits and bond markets.   The markets are only willing to lend because the European Central Bank is either transferring tax income from the wealthier Eurozone states to the poorer, or simply printing money and damn the long-term growth and inflation consequences.

Take Greece.  Total Eurozone exposure to Greek debt is about €300 billion ($390bn) or some 3% of Eurozone GDP.  German exposure to Greece alone is approaching 5% of GDP.  Six Eurozone states have now sought bailouts with Slovenia about to follow when it is politically appropriate for their banking crisis to be publicly declared.  As each crisis unfolds foreign investors are pulling out their money forcing the ECB to plug the gap by impoverishing the northern, western European taxpayer.

Economic theory suggests all six debtors should leave the Euro, devalue and thus regain competitiveness.  However, in so doing the already immense social pain being suffered will only deepen (Spain’s unemployment rate yesterday reached 27.16%). Moreover, even if only Cyprus, Greece, Ireland, Portugal and Spain pulled out the costs of transitional arrangements could be as high as €1.2 trillion ($1.6tr) or 15% of Eurozone GDP.  That increases to around 20% of Eurozone GDP when the likely additional bank bailouts are factored in.

Consequently, and here’s the rub, Germany is likely to see its national debt increase from 81% in 2011 to around 100% in 2014-15.  German banks alone would need an injection of €500 billion ($600bn) if the Euro fails due to their exposure to toxic debt, threatening the loss of Germany’s AAA credit rating.  However, go the other way towards banking and fiscal union and that would cost €300-€400 billion ($390-$520tr) with Germany bearing at least 30%.  Therefore, post-German elections in September some form of debt mutualisation is inevitable which will push German interest rate costs up by €15 billion ($19bn) per annum.  Indeed, simply holding the resources of the poorer EU states at their current levels to pay for welfare is likely to require transfers from north to south of €250 billion ($325bn) per annum.

Which brings me back to Britain.  The Brits are also sort of broke, with the British national debt likely to peak at around 85% 2017-2018.  However, debt is relative and British debt compares with Japan at 194% and Italy over 100%.  Moreover, Britain’s national debt is only 30% of that between 1920 and 1960.  More importantly 70% of British debt is held in the UK, whereas with the notable exception of Italy, up to 100% of southern European debt is held by flight-risk foreigners.  In other words the British enjoy more flexibility than any Eurozone country, unless that is they are suckered into paying for the Euro-disaster.

The future?  In the long run Germany will consolidate its position as Europe’s strongest economic power, but the crown it wears will be hollow given the constraints imposed on it by Eurozone debt.  Britain will remain and strengthen its position as Europe’s second biggest economy and strongest military power.  Critically, damaged by the crisis and enmeshed in  ever-expanding, growth and competitive-killing Brussels regulation both will decline in relative terms against North America and Asia-Pacific. 

As for long-runs John Maynard Keynes was right; we are all dead.  A crumple zone indeed. On that happy note...

 

Julian Lindley-French