Supporters of the European Union – both over here and over there – are wilfully blind to it, but the EU is facing a series of crises much greater than we are facing in this country, as a result of the Prime Minister’s catastrophic Brexit negotiations. I will discuss these in order of increasing severity and urgency. The EU has shown itself incapable of doing anything about them, except to have even grander plans for a European Empire, with the UK as its first colony. You couldn’t make any of this up.
The political crisis in Europe
On the political front, the Franco-German axis that has driven the EU since the 1950s is weakening. Angela Merkel’s power in Germany is draining away as a result of her mishandling of the 2015 refugee crisis which is costing Europe hundreds of billions of euros. In France, Emmanuel Macron’s attempts to reform the bloated welfare state have floundered as a result of a few thousand yellow vest protestors. Eurosceptic parties are growing in strength in virtually every member state, further weakening the axis. The openly illiberal democracies of eastern Europe are equally openly flouting EU laws.
However, this is slowly developing problem for Europe – and you’re not going to lose sleep over this, not tonight at least. Nevertheless, the EU will be losing sleep a lot sooner if the UK leaves without paying the £39bn divorce bill. Gunther Oettinger, the European Commission (EC)’s finance chief, has warned that other member states will face a significant increase in contributions and that Germany will refuse to make up the shortfall alone.
The economic crisis in Europe
This is much more serious. One of the key reasons for the yellow vest protestors is the poor state of the French economy. It has grown at less than 1% pa since 1980 and unemployment is currently at 9%. One explanation for this is an unreformed labour market – well illustrated by the 35-hour week and a retirement age of 60. Another is some of the highest taxes in the world to pay for those welfare benefits. It was the planned increase in diesel fuel duty which started the yellow vest movement in the first place.
Yet a 1% annual growth rate is a luxury compared with Italy, where the economy has not grown at all since it joined the euro. Italy’s unemployment rate is 10%, while its youth unemployment rate is 35% and has averaged above 30% since 1983. The corresponding figures in Spain are 15% and 34%. Germany’s unemployment rate is only 3.5%.
There’s a very simple reason for all this and that’s the euro. When the euro started in 1999, Germany joined at too low an exchange rate, while the Mediterranean states joined at too high exchange rates, for the long-term sustainability of the euro. This gave Germany a competitive advantage when it came to intra-EU trading. Initially this was not thought to matter, since competitive pressures in the different member states’ labour and capital markets would eventually pull the rest of the EU up to German levels of productivity. But it is clear from these unemployment figures that this did not happen.
Furthermore, the EU has supposedly strict limits on the size of member state budget deficits – they must not exceed 3% of gross domestic product (GDP) or 2.2% if the member state is also in the eurozone – and national debts – they must not exceed 60% of GDP. These limits apply whether their breach is due to an economic recession beyond the control of the member state or due to government spending profligacy. In addition, no distinction is made between current and capital expenditures.
Italy’s budget deficit is 2.3% of GDP, while its national debt is 133% of GDP, the second highest after Greece. The new eurosceptic Italian coalition government of the League and Five Star Movement has proposed increasing the budget deficit and hence aggregate demand in an attempt to pull the economy out of recession, by cutting taxes and boosting welfare spending. This has caused a big public fight with the EC. Less well known is the fact that the EC has also rejected the Spanish government’s 2019 budget plan for reducing its deficits as inadequate. Spain’s budget deficit is 2.7% of GDP, while its national debt is 97% of GDP.
Macron’s capitulation to the yellow vest protestors using budget handouts has not only shattered his credibility with Germany, it has put him in the same camp as Italy in terms of breaching EU rules: France’s budget deficit and national debt will increase to 3.5% and 100%, respectively. Luigi Di Maio, leader of Five Star, responded: ‘If the deficit-to-GDP rules are valid for Italy, then I expect them to be valid for Macron’.
It is clear that there are serious structural imbalances in the EU economy which are impossible to correct as a result of the EU’s obsession with rules and processes rather than outcomes. The result is a permanent deflationary bias across the region.
And this is about to be exacerbated by the European Central Bank (ECB)’s response to the Global Financial Crisis (GFC). Its quantitative easing (QE) programme – which involves buying up government and corporate bonds – began too late (in 2015, eight years after the GFC started) and has been ended prematurely (at the end of 2018), given the current state of the eurozone economies. This is despite introducing €2.7 trillion of liquidity into those economies, equal to 25% of eurozone GDP (€2.7 trillion/€11 trillion) – and in the process driving up bond prices and driving down their yields. Eurozone growth has averaged 2.2% since 2015, but, according to estimates by UBS investment bank, 0.75% of this is due to QE.
The growth rate is currently just 0.8%, the lowest level for four years. Italy’s growth rate is zero and it is about to enter its third recession in ten years. While there are contributory external factors – most notably a slowdown in growth in China, a big importer of European cars and machine parts, as a result of the trade war with the US – most of the eurozone’s problems are internal. Even the German economy contracted by 0.2% in the third quarter of 2018, largely due to a 30% fall in car sales following the ‘Dieselgate’ emissions scandal. Germany is the engine of growth in the EU and if that falters, then the whole continent is in trouble.
Yet the pressure to end QE came from Jens Weidmann, head of the German Bundesbank, ever mindful of Germany’s perennial concern about the inflationary pressures that the massive increase in liquidity could unleash. The ECB’s four-year QE programme was much larger relative to GDP than the $3.6 trillion US equivalent which lasted six years from 2008 to 2014, only added liquidity equal to 19% of US GDP ($3.6 trillion/$19.4 trillion) and resulted in a stable growth rate of 2% since 2008. The UK’s seven-year QE programme between 2009 and 2016 added liquidity equal to 22% of GDP (£435bn/£2 trillion) which helped to grow the economy by 2% pa since 2010.
As the Italians are discovering, recession is preferred to inflation in the German-dominated eurozone. The ECB was the only non-Italian institution buying Italian government bonds – as part of the QE programme – and that has just stopped. Under the rules of Economic and Monetary Union (EMU) relating to the Stability Pact and Fiscal Compact, the EU has no mechanism for using fiscal policy as an alternative to a monetary policy like QE. This would require the fiscal union of EU member states – setting member states budgets and tax rates centrally in Brussels. Without this, Italy’s recession will be permanent.
The financial crisis in Europe
But these problems are as nothing compared with the financial crisis that is developing in the eurozone banking system. The zone’s main ‘globally systemically important banks’ are pretty close to being insolvent. One reason is the low returns on assets following QE which has reduced bank profits, despite even lower returns on deposits. But all banks globally face this problem.
What makes banks in the eurozone different is the myth perpetuated that their countries’ sovereign debt is risk free. As explained by Stephen Morris and Patrick Jenkins in a recent article in the Financial Times: ‘Banks may hold a limitless amount of EU government bonds on their balance sheet with no capital requirements because the assets are assumed to be so safe they carry a “zero” risk weight. As a result, banks have accrued large stockpiles of the debt, particularly of their home nation for political reasons. However, the bonds have repeatedly proved risky and in times of crisis can be volatile, for example in Greece in 2015 and Italy this summer [of 2018]. When debt prices fall and yields rise, banks are forced to reprice their holdings and may have to reduce lending and raise capital to survive, further undermining the health and stability of their home country’.
The risk is greatest in Italy where the banks are the most exposed in Europe, holding €387bn of Italian government bonds, equal to 10% of their total assets. The two largest banks, Intesa Sanpaolo and UniCredit, have bigger exposures than their balance sheet capital is able to absorb in the event of default. Given the size of Italy’s national debt, there is the danger of a ‘doom loop’ developing if the Italian economy fails to grow sufficiently to pay back the debt when it is due. Equally serious, Italian banks have a significant exposure to non-performing loans (NPLs) made to private-sector companies – a euphemism for interest and loan repayments not being made. The total value of NPLs is €264bn, around 17% of total loans made by Italian banks. About half of these loans are secured against collateral, but they are still only worth 25-30% of face value. Across the whole of the EU, the total value of NPLs is €780bn.
The election of the new Italian government in May caused international investors to offload their holdings of Italian bonds, leading to a fall in prices which, in turn, reduced the value of the assets held on the banks’ balance sheets. The government will be expected to protect its citizens’ bank deposits, but this would require it to raise taxes or borrow – both of which are effectively impossible if the economy is in recession. Further, strict state aid rules in the EU prohibit the widespread rescue of private-sector banks. So, a vicious downward spiral develops in which the economy is not strong enough to rescue either the government or the banking system. And the banking system is not strong enough to provide the corporate loans needed to grow the economy. In January 2019, the European Central Bank was forced to rescue Banca Carige, Italy’s tenth largest bank with 482 branches.
Matters are made worse by Target2, the eurozone payments system. As I have written elsewhere in Briefings for Brexit, Target2 converts private-sector loans between eurozone members into sovereign loans – which are again treated as risk free. In short, Target2 has become a giant credit card for eurozone members that import more than they export to other members. But there are two differences compared with a normal credit card: the interest rate is zero and the loan never needs to be repaid. At the end of 2018, Italy and Spain owed around €500bn and €400bn, respectively, which they can never pay back and Germany was owed more than €900bn. The Italian government wants €250bn of its Target2 debits cancelled, but Germany has refused – yet it will never recover any of this.
Target2 is also being used to facilitate capital flight, because residents in Italy and Spain have lost confidence in their banking system. Those with bank deposits above €100,000 are liable for an 8% haircut if their bank becomes insolvent. The funds are being deposited in German banks. This is causing enormous distortions in Europe’s financial markets as Germany becomes flooded with money that it cannot use productively and there is a corresponding dearth of funds for investment in the Mediterranean states. German interest rates have been negative since 2014. A study by Germany’s Postbank estimates that German savers lost interest income worth €125bn between 2011 and 2015 as a result.
Even worse is the risk of contagion with the problems in the Italian banking system spreading to other member states, since banks and insurance companies in these countries have significant holdings of Italian debt. France is particularly badly affected. French banks have an exposure to Italian debt equal to 11% of French GDP. The largest exposures are BNP Paribas (€19bn), Groupe Crédit Agricole (€11bn), Groupe BPCE (€9bn), and Société de Financement Local, SFIL (€6bn). Many of these loans are non-performing. As a result, many French banks are, like their Italian equivalents, technically insolvent.
German banks are also exposed to Italy, although to a lesser extent than France. However, they face different problems, in particular, the consequences of investing in complex derivative contracts where the risks were poorly understood. The key culprit is the once mighty Deutsche Bank, although Commerzbank is also in difficulty. In 2016, the IMF declared that Deutsche Bank was the greatest global contributor to systemic banking risk. The bank’s shares halved in value and the most talented staff, whose bonuses were linked to the share price, left. In 2018, it slipped to a 10-year low in the dealmaking league table. Another doom loop.
The EU is incapable of agreeing solutions to these crises – and instead has plans to create a European Empire…
There are, in principle, three measures that the EU could take to ameliorate the financial crisis.
The first is to recognise that eurozone sovereign debt is not risk free and hence should not have a zero risk weight in banks’ balance sheets. Amazingly, it was only in December 2018 that this issue was raised at a senior level in the EU by Danièle Nouy, the eurozone’s chief banking regulator, and Olivier Guersent, the EU official responsible for financial services. The second is to limit the amount of own-government bonds that a bank can hold on its balance sheet. This has been repeatedly proposed by the Bundesbank, but is opposed by the more indebted countries keen to get their banks to buy the bonds that they issue. A third is a Europe-wide deposit insurance scheme – which involves risk pooling across the eurozone – to give confidence to bank customers in all eurozone member states, to reduce the risk of capital flight, and hence enhance financial stability.
These are all essential components of the ultimate plan for a European Banking Union. But they are a long way from being implemented. Germany won’t consider deposit insurance – which would have the effect of moving individual country default risk to the European level and hence putting it on the hook – before countries like Italy place strict limits on the amount of Italian bonds their banks can hold. As a result, Isabel Schnabel, a member of the German Council of Economic Experts, has said ‘the eurozone remains fragile. Without cutting the cord between sovereigns and banks, the so-called sovereign-bank doom loop, completion of the banking union is impossible. A fiscal backstop for the single resolution fund, the EU’s rescue fund for failing lenders, and rules covering non-performing loans are not sufficient. Worries about Italy have led some to reject any further risk-sharing in the eurozone. But political instability there shows that action is urgently needed’. But this is not on the political agenda at the EU. And the Sentix Euro Breakup Index at its highest level for more than two years. Sentix’s Manfred Hubner said it brought back ‘dark memories’ of the months leading up to the GFC, with ‘practically no glimmer of hope’ anywhere.
All this affects banks in the UK too. While they have low exposure to Italian banks, they have considerable exposure to French banks, so a domino effect is possible. Even the europhile Bank of England has warned that a bank crisis in Italy could spark a doom loop in the UK: ‘if financial strains were to spread across the euro area, there could be a material risk to UK financial stability’.
However, dealing with the financial crisis won’t help in the long run if measures are not also taken to deal with the economic crisis which, in turn, means dealing with the political crisis. Bruno Le Maire, the French finance minister, has made it very clear what the implications are. He says that it means fiscal union in the EU: ‘Either we get a eurozone budget or there will eventually be no euro at all. If there was a new financial and economic crisis tomorrow, the eurozone could not respond’.
This, of course, will only work if there is also full political union, but M. Le Maire went beyond this and called for Europe to become an ‘empire, like China, and the US [willing to deploy its full economic, monetary, technological, and cultural power on the world stage to confront the two great superpowers]. I am talking about a peaceful empire, based on the rule of law. I use the term to sharpen awareness that we are going into a world where power matters. Europe should no longer shrink from deploying its power’.
…with the UK as a non-voting colony
Now you can begin to see why the EU has been so keen to take control of our financial system in the Brexit negotiations. This includes the capital markets in the City of London, our banks, building societies and pension funds. Collectively, these are three times the size of the other countries in Europe – Canary Wharf alone does more financial services business than the rest of the EU combined. This is because traditionally the continent has used banks and assurance companies rather than capital markets to provide loans to customers (the so-called bancassurance model), but as we have seen, many of these are insolvent.
Powerful voices in the EU would like to rescue their banking system by imposing a ‘financial transactions tax’ every time a transaction takes place – this would be collected by the EC in Brussels. Three times more would be raised from us than from customers on the whole European continent. The tax per transaction would be small, so it would not be immediately obvious what is happening. But these small taxes add up and they would be used to bail out Italian, Spanish, French and German banks – with your hard-earned savings.
So there you have it. The EU and the house of cards it has built is slowly collapsing before our very eyes, and yet Europe’s leaders want to create a new European Empire to take on China and the US. They have already shown what paper tigers they are when it came to Russia’s annexation of the Crimea – which was a direct consequence of EU negotiations to bring Ukraine into the EU. This is an empire that will soon disintegrate – with Bruno Le Maire as the new Nero fiddling while Rome (and Paris) burns.
In the meantime, the Withdrawal Agreement makes the UK a non-voting colony that will be drained of its assets to save our new colonial masters’ financial system and then to finance their imperial ambitions. No wonder all the EU27 leaders were tripping over each other to sign up to it on 25 November 2018.
Leaving the EU involves nothing more than a minor change in our terms of trade on 12% of our GDP, yet Theresa May’s negotiating incompetence has created the biggest political crisis in this country since 1940.
Our country and our continent are governed by fools. And we would be the biggest dummies in our history if we allowed them to get away with this. We need to leave the EU now! There is no time left for more dithering.
Professor David Blake is at Cass Business School