The Euro at 20

Twenty years ago last weekend, people across Continental Europe started handing euro notes to shopkeepers and café servers—and a new physical currency was born. An experiment thus began playing out in real time: How could low-inflation northern European countries share a currency and monetary policy with higher-inflation southern Europe, especially if the bloc wasn’t a fiscal transfer union? Warnings about this north-south divide have dogged the currency ever since—and still hog headlines today, despite the euro surviving a trial by fire in the past decade’s regional debt crisis. Yet since the regional bear market that accompanied said crisis, this existential question—and the long-running, slow-moving efforts to solve it—have largely faded into the background, with little sway over stocks for good or ill. In our view, this is helpful to keep in mind as some once again warn the euro could split and send markets reeling. Stocks are very familiar with the euro’s structural issues, and there is little surprise power left.

The threat many still see: The north-south divide is too wide to surmount. At the heart of the debate is whether one monetary policy—the ECB’s—fits all, especially with German CPI inflation hitting a 30-year high in December. Pundits claim the ECB’s winding down its pandemic-spurred emergency monetary policy programs will prove too early for many countries still struggling (southern Europe). Or too late, risking overheating and runaway inflation in others (northern Europe).

This isn’t exactly a theoretical fear. The collapse of the European Exchange Rate Mechanism (ERM) in the early 1990s—and the subsequent European recession—illustrates the risks. Back then, Germany’s Bundesbank was keeping rates high to quell inflation after reunification, forcing all other participants in the regional currency peg to do the same. That didn’t work well for southern European nations, which needed lower rates to support the recovery from their economic contractions in 1990 – 1991. As countries first defended, then discarded the currency peg, it brought monetary chaos and a true double-dip recession.

Some say a similar situation could be arising now. This time around though, the perception is southern Europe has the better side of the argument—and ear of the ECB—based on how big the central bank’s quantitative easing program is and how long negative rates have lasted. If inflation-phobic northern Europe disagrees, some suggest the euro could splinter.

Underlying all this is the notion of a “two-speed” eurozone. If southern eurozone countries, e.g. Italy and Greece, remain structurally uncompetitive, they allegedly might be subject to rolling bailouts in one form or another. In a monetary union that isn’t also a fiscal transfer union, where wealthier countries’ taxes make up budget shortfalls for those less well off—institutionalized transfers members all agree to—financial crisis is, supposedly, inevitable. Weaker countries will rack up debts until they can’t pay them—or they are cut off—at which point, unable to inflate them away without a printing press, they enter a deflationary debt spiral, possibly including a “doom loop” (for extra style points) if their banks are holding the bag.

If this happens repeatedly, it would seem northern powerhouses, fed up, would either force southern stragglers out or leave to form a league of their own. Or, some have suggested, create a second-tier minor league to, as they say in European football, relegate countries that don’t measure up—with their own parallel currency.

All these issues have been well known from the start, though—it isn’t as if the euro’s architects weren’t paying attention during the ERM crisis. The problem is solutions for them are politically contentious. Somewhat helpfully, though, Europe’s rolling sovereign debt crisis from late 2009 through the early teens, which caused a regional bear market and recession, brought them into the spotlight—spurring (slow-moving) action. In typically bureaucratic fashion, the eurozone has since launched several long-running initiatives to address its underlying structural weaknesses.

At the time, we surmised that the solutions under discussion wouldn’t take months, but years to work out, becoming part of the long-term structural backdrop as they played out in fits and starts. That has largely happened. Take efforts to establish the banking and fiscal unions that many think are necessary for the monetary union to work. Banks once regulated mainly at the national level are increasingly supervised by the EU under a single rulebook—to monitor for financial problems and resolve any under a common framework. However, some don’t think a banking union will be complete until there is an EU-wide deposit insurance scheme. While proposed, it hasn’t adopted one yet. Without EU-insured deposits, proponents say, banks will remain beholden to national governments, perpetuating tight ties between them and ripe doom-loop conditions.

On the fiscal side, the pandemic brought a bit of a breakthrough. For the first time, to fund its recovery efforts and “green” initiatives, the EU issued its own bonds, which global investors snapped up, and distributed the proceeds among member states. This may be a one-off—we haven’t seen much to indicate the EU is ready to go to the well regularly to establish a deep and liquid EU bond market, like for US Treasurys.

Meanwhile, the EU has also been making strides toward greater political integration. For example, in November, after years (and years) of negotiations, the European Parliament finally overhauled its Common Agricultural Policy, governing the EU’s extensive farm subsidies—although the reforms won’t take effect until 2023. While seen as more fair by many, some don’t think the new version goes far enough to protect the environment and prevent climate change. Other issues abound, from migration and the rule of law to the recent energy crunch and geopolitical friction. Like everything else, the EU is tackling these methodically—with steps forward and backward.

Through all of this, European political institutions have demonstrated a remarkable will and level of commitment to hold the currency union together. Such tenacity we think is more than most appreciate. See the aftermath of Greece’s 2015 referendum with any questions: the one where Greek voters rejected a bailout (and prepared to Grexit)—yet stayed anyway. How did that turn out? To take one indicator, Greek 10-year government bond yields now stand at 1.37%, below equivalent maturity US Treasury yields’ 1.71%.^[i] There is no way to prove a counterfactual, but we rather doubt this would be the case if Greece was out of the eurozone. This underscores the political motive to support the euro: The clear economic benefit it can bring—and with it, the shared European identity that helps forge to bridge historical divides, which so often led to counterproductive conflict in the past. That is likely especially important to EU leaders now, with Russia on the move and China ascending.

For markets though, this is a lesson they learned a while ago. Stocks don’t seem too interested in all the detailed steps and political niceties to keep the eurozone whole—and to expand it—so long as a big sudden change doesn’t create winners and losers. Absent that kind of regulatory or policy wallop, which doesn’t appear likely for now, these efforts are probably just part of the structural backdrop, not cyclical drivers. But stocks are far more concerned about the cyclical outlook over the next 3 to 30 months. What the economy and earnings do in that timeframe are of much greater relevance to investors than incremental policy progress (or setbacks) on the long road toward completing a more perfect euro.^[ii]