Merlin Weekly Macro: A death and a birthday in the EU family

The EU: a death and a birthday in the family

Two milestones have just passed in the EU family: one was the death on December 27th of Jacques Delors, EU Commission President from 1985 to 1995, at the age of 98; the second on New Year’s Day was the 25th anniversary of the introduction of the single currency and the birth of the euro. Delors and the euro are inextricably interlinked.

A controversial character, a sample of the newspaper headlines on Delors’ passing tells the story of his divisiveness from each of their own narrow perspectives: “Jacques Delors was the father of Brexit…” (UK Daily Telegraph); “Jacques Delors was the grave digger of ‘social Europe’” (The Jacobin, the US house paper of the American Left, reflecting Delors’ political shift from socialism towards the acceptance of global capitalism); “Macron leads Paris tribute to Jacques Delors, architect of European integration” (France 24). However, for British readers of a certain age, none will compare with “Up Yours, Delors!”, the front page headline in The Sun on 1st November 1990 at the very height of Margaret Thatcher’s battles with Europe and following her famous direct put-down at the Commons’ Dispatch Box to Delors’ demand for full European integration, “No! No! No!”. It is neither a surprise nor a secret the Lady and Delors detested each other.

A significant figure at a pivotal time and with a strong intellect, Delors was one of those among the European leadership whose political formative years were both during the Second World War and its immediate aftermath. That direct link with the carnage created by the rise of fascism was a powerful motivation for politicians of Delors’ generation: the eventual vision for a global superpower as strong as the United States and Russia was born from the simple imperative of “never again”. Never again would totalitarianism in Europe in whatever form be allowed to take root; the initial step to prevent it was the European Coal and Steel Treaty, signed in April 1951 between France, Belgium, Holland, Luxembourg, West Germany and Italy, creating a trade community allowing the free movement of steel and coal within the membership’s perimeter. Coal and steel were the backbone commodities of the modern, post-war industrialised economy; freeing up the sources of production and distribution would prevent any future concentration and control which could allow the re-armament of any member nation with the intention of militarily threatening its neighbours.

Unlike his successors who almost without exception have been political and intellectual featherweights in comparison, Delors had a clear and strongly articulated strategic vision and ambition for the integration and development of the expanding European Union. The culmination during his presidency was the signing of the Maastricht Treaty in 1992. Maastricht secured the path to the dissolution of qualifying member states’ currencies and the introduction of the euro at the end of the decade. Delors did not see the creation of the euro as an end in itself: it was merely a fundamental stepping stone to full European political and fiscal integration. His aim was the birth of a single European state with global reach and power.

EU integration: the curse of Tantalus

A quarter of a century later, thanks to too many members, splintering national agendas, woeful leadership and the EU sinking under the weight of its own confused governance, his ambition for European integration remains unfulfilled. Last autumn, Mario Draghi, a former President of the European Central Bank and failed Italian Prime Minister, made a baleful call for full European integration. For all the response he got, he might as well have been whistling in the wind.

In these columns we have had cause to rehearse ad nauseam all the political and structural shortcomings of the Union. That we are still writing about it is because little of strategic substance changes. The next logical progressive step is too great; equally to go backwards spells defeat and potential chaos. What the Union does instead is to spend much time and effort plugging holes to keep the ship just about seaworthy.

Adaptive cruise control: Stability and Growth Pact 2.0

Take the fiscal rule reforms agreed in December. The financial structure of the Union (but it is of most importance to the 20 members–Croatia joined on 1st January 2023– of the eurozone which employ the single currency) is predicated on a blanket series of rules including two supposedly inviolate principles underpinned by the Stability and Growth Pact. Those principles are: 1) no member state’s government debt should exceed 60% of GDP; and 2) no government should incur an annual deficit (i.e. a negative balance between its income and expenditure) of greater than 3% of GDP. Currently, of the 20 members of the eurozone, eight countries meet the Debt/GDP criterion and 12 satisfy the 3% annual deficit rule; only six countries meet both criteria (Estonia, Ireland, Lithuania, Luxembourg, the Netherlands and Slovakia); those six might be 30% of the nominal membership however they only account for 13% of the eurozone’s GDP. The heavyweight economies, Germany (66% Debt/GDP; 2.5% deficit), France (112%/-4.8%), Italy (142%/-8.0) and Spain (112%/-4.7%), between them 73% of eurozone GDP, are in breach and with the exception of Germany’s budget deficit (in which except in the case of designated emergencies, currently the subject of intense debate in Germany following its 2024 budget being ruled illegal, it is against the law for the government to present a budget with a deficit greater than 0.35% of GDP), they are serial offenders.

Hard-headed if cynical pragmatism says that if the members cannot stick to the rules and are impervious to any potential sanctions for breaking them, then change the rules. That was done in December. Out goes the blanket, crystal clear, binary one-size-fits-all Stability and Growth Pact of yore, and in comes a modified system whereby each country has its own bi-lateral agreement with Brussels (i.e. the Commission): it can present spending plans appropriate to its own domestic needs and circumstances but the plan must include a provision to reduce debt over a measured period towards 60%, and if its deficit/GDP exceeds 3%, any excess should be limited to 1.5% of GDP with the intention of returning to below 3% (though that 3% ceiling is relaxed from an annual absolute to what is termed an “intertemporal period” i.e. to use an Americanism, ‘whenever’).

Economists at the LSE and the International Centre for Economic Policy Research have shed light on the potential flaws. When considering debt, the new system calculates the ‘sustainability’ of that debt (i.e. the capacity for the economy to support its own borrowings, the creditworthiness of the government and if it can afford consistently to service the interest) on 4,7 and 10 year horizons. The debt sustainability assessment (DSA) for each country is made by the Commission which has the power to reject proposed spending plans. In that DSA however, the Commission has no control over monetary policy, it has no greater visibility than anyone else over the interest rate outlook; economic growth ‘forecasts’ are little more than conjecture of exponentially diminishing utility and accuracy the further into the future they look. Who is to say that the Commission has the monopoly on being correct about the outlook? Surely these are both areas for major disagreement in this new bi-lateral system, if not among today’s signatories who were direct parties to the new rules, but potentially their successors. The amended system also allows an element of influence in national fiscal policy: when considering the deficit, the Commission will only look at net spending (i.e. expenditure net of tax receipts) and, controversially, deems a tax cut explicitly as an increase in expenditure; it also makes assumptions about what is ‘good’ expenditure (and by inference what is ‘bad’).

The question is, will the new system work any better than the one it replaces? To which the answer as ever with the EU is that some members will play by the rules for which they get no credit; of the ones who don’t, those who shout the loudest or throw their weight about, or simply carry on regardless diplomatically telling Brussels where to go, usually get away with it. It is always important to remember that while the Commission (the civil service) is there to implement policy, policy itself is determined by the EU’s political wing, the Council of Ministers; individual ministers will always dissemble, haggle, stamp their feet and twist arms if the wind is not blowing the way of their national interests. It is the nature of the beast. More pertinently, their national electorates expect it.

 “Your logic is seriously flawed”.

While all of this technical reordering of the deckchairs is an acknowledgement of the reality of a system that functions but which is fundamentally dysfunctional, there is no escape from one simple fact: the core structure of the eurozone is as economically illiterate as it is constitutionally (in its literal sense) absurd. As Dr Spock would say, it is illogical.

Consider: when assessing the appropriate monetary policy, whether interest rates or the extent of Quantitative Easing or Tightening, the ECB reflects on pan-eurozone data as though the bloc is one single homogenous unit: inflation at 2.9%, growth of -0.1%, unemployment of 6.5% etc. But the reality, in the absence of fiscal union, is 20 separate national economies, all with widely differing tax regimes, employment and welfare policies, social constructs and fiscal priorities (e.g. neutral Ireland spends only 0.23% of its GDP on defence, while NATO member Greece spends at 3.8%, nearly double the recommended minimum NATO requirement). How is a uniform ECB interest rate, currently of 4.5%, appropriate? Look at the most recent reported low and high ranges on some key indicators, all directly linked with economic activity and financial health; quarterly GDP growth: Ireland -1.9%, Malta +2.4%; inflation: Italy and Latvia 0.6%, Slovakia 6.3%; unemployment, Malta 2.5%, Spain 11.8%; the debt burden as measured by debt/GDP, Estonia 18.5%, Greece 172.6%; government spending/GDP, Cyprus a surplus of 2.4%, Italy a deficit of 8.0%.

A blanket, homogenous monetary policy cannot disentangle that lot. And it does not. 17 countries have positive real interest rates including Italy’s and Latvia’s of 3.9% but Italy is nursing 141.7% debt/GDP while Lativia’s is almost exactly 100pts lower at 41.0%; that is perverse. Simultaneously, Austria has a negative real interest rate of 1.1% and Slovakia 1.8%. At the poles within the zone, currently there is a real interest rate spread of 5.7 percentage points. This is Alice in Wonderland economics, policy of the make-believe.

In context, the same reported UK and US data are respectively: quarterly GDP growth -0.2%/+4.9%; inflation 3.9%/3.4%; unemployment 4.2%/3.7%; Debt/GDP 97.1%/129% (in reality closer to 140% today); spending/GDP -5.0%/-3.7%; our respective interest rates are similar at 5.25% and 5.5% but have taken quite different paths to get there from zero more than two years ago and the Federal Reserve and the Bank of England are free to make their own decisions about the future path of monetary policy appropriate for their respective circumstances. That does not apply to the 20 members of the eurozone and a central ECB diktat.

The gradual disintegration of EMU

In past musings we have described eurozone monetary union as a chimera. A symptom was the need for creative capital instruments provided by the ECB to prop up weak commercial bank balance sheets, especially in Italy, when the central bank adopted its corrosive policy of negative interest rates. But the first systematically created cracks appeared in July 2022 and the ECB’s delayed reaction to the inflation crisis. Amid significant volatility and widening of spreads in European bond yields between the fiscally conservative economies and the fiscally incontinent, the ECB was forced to adopt divergent approaches to the mechanics of central bank bond strategies. Despite much rancour and accusations of exceeding its authority, it adopted a policy to be able sell bonds of the stronger countries while buying those of the weaker ones. This became known as the ECB’s Anti-fragmentation Programme, an explicit endorsement that a one-size-fits-all policy does not work. Last month, as we have described, more foundation stones were removed from the monetary union edifice with the significant amendments to the Stability and Growth Pact, and particularly the introduction of those individual national bi-lateral fiscal agreements with Brussels.

The imminent death of the euro has been predicted on many occasions over the past quarter of a century. In every case it has been wrong. We are certainly not predicting it now. Unless there is some earth-shakingly political event such as Holland, or Italy, or potentially France under Le Pen deciding to leave the Union (and any of these, while not impossible, is extremely unlikely given the ensuing financial chaos, something that was not applicable with Brexit thanks to our not being in the euro), the chances of the euro’s demise are vanishingly small. However, in the absence of any meaningful progress towards political, fiscal and debt union (and remember, “Europe” is entirely a political project: only political willpower will deliver full integration), monetary union as originally envisaged has proven not only half-baked but unsustainable.

However much the agreed policy developments described above are pragmatic, adaptive or evolutionary, and however well they are managed, make no mistake (and the EU authorities will flatly deny it): European Monetary Union is literally disintegrating.

Politics is polarising in many EU member states. In most cases at the extremes, whether right or left, nationalist tendencies are increasingly to the fore. But even if the great majority of Europeans are still in favour of membership of the EU and its perceived benefits of “we’re all better off together”, political momentum for full integration has all but evaporated. It may return, or it may never happen. But for now at least, Delors’ dream of a fully formed, pan-European superstate remains just that: a dream.

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