United States Of Europe
December 1, 2011 by Daniel Zurbrügg
Today’s sovereign debt problems in Europe and the United States create the single biggest risk for Western economies. In order to deal with the economic challenges, the European Union is becoming an increasingly integrated and centralized structure.
I have never been a big fan of the EU and its currency, the euro. When the European Union signed the Maastricht Treaty in 1992, a core group of European countries agreed to adopt the euro as their main currency, with the object of eventually replacing individual currencies, such as the deutschemark, the French franc and the Italian lira. Seven years later, the euro was officially introduced in non-physical form. Finally, in January 2002, the euro was introduced in physical coins and notes.
At that time, I thought it impossible to bring so many different countries together and have all of them adopt a common currency. In my view, these countries were too different from each other to be merged into a single currency bloc, given huge economic and cultural differences, as well as different languages. Because I am Swiss, I am always skeptical of large and centralized political systems like the EU and even the United States. However, I have to admit that the European Union and the integration of many countries over the past 20 years worked much more smoothly than I thought it would.
I was also surprised by the convergence of European bond premiums. In the old days, it was normal that Italy had a higher risk premium than German government bonds. But over the years, that yield spread narrowed so much that credit markets viewed the credit risk of Italian bonds as being equal to the risk of German government bonds — even though Germany appeared to be in a much better position.
The European debt crisis brought this credit risk convergence to an end, and spreads started to widen again. I consider this a very healthy development, since the market has been repricing the risk of these bonds. The result is that Italy pays more for its debt, because the market perceives it to be riskier than Germany. What should the yield spread be between these two countries? This question is hard to answer, but I believe it is clear that the difference should be quite significant.
Earlier this week, Italy was issuing bonds with a 12-year lifetime at a yield of 7.30 percent, and Belgium issued 10-year bonds at a yield of 5.65 percent. Even though these yield levels look extremely high, the rates are down slightly from their peaks several days ago. For quite some time, it was not even clear whether Italy and Belgium could successfully place bonds in international markets.
In comparison, Germany can borrow from financial markets at a rate of below 3 percent for 10 years and is paying just 3.02 percent on 20-year bonds. Italy is paying more than twice the yield on its bonds than Germany. In addition, Italy’s funding costs are significantly higher. In fact, Italy’s funding costs are at levels not sustainable in the long run. The same is true for other EU member states such as Spain, Portugal and Greece.
The challenge the EU faces is that for most of its member states, the overall funding costs are now significantly above levels that can be considered sustainable. In the short run, these countries can be supported by the European central bank, the European Stability Fund or even the IMF, but this will not solve the real underlying problems in the long run. In my view, it is a not a question of “if” but “when” the EU will start issuing Eurobonds, similar to Treasury bonds in the United States. The money raised from those bonds would be used to finance individual member states through a central funding institution that acts like a Eurobank. The Eurobank would directly negotiate funding terms and conditions with individual member states that need money.
There is currently a lot of debate about this, but I don’t think the European Union has another option that would bring down borrowing costs. This also means that economically strong countries like Germany would probably pay slightly higher rates, but would still have the opportunity to issue its own bonds — if it could do so at lower yields. From a political and economic point of view, I don’t like this development, but the question today is: What other options does Europe have? In my opinion, there are none.
Again, I don’t like a setup like the EU, a centralized system in which an individual member state loses more and more of its voice. But Europeans have taken this project so far that I think the point of return is far behind them. It is absolutely critical for the EU to bring down funding costs, raise confidence among financial investors and stop the attacks on individual member states. All of these practices put the future of the EU at risk.
I think the EU is an odd concept and setup, and I doubt it will work very much longer. But now, there is no way back. That is why I think Eurobonds will be issued soon in order to calm financial markets.
Eventually, U.S. Treasury bonds and Eurobonds are going to be almost the same. Also, the underlying debt problems of the U.S. and the EU are going to be similar in size, and I am almost sure that both will print money to deal with the debt burden. The likely consequence will be that both are going to have structurally weak currencies, and investors should make sure not to hold too much exposure to these two currencies.
I don’t know which of the two currencies will be stronger in the long run (or should I say “less weak?”). Against the U.S. dollar speaks the fact that its global influence is in decline, after being the world’s dominant currency for more than 60 years. On the other hand, the euro is still a relatively young currency; and the fact that so many economically and culturally diverse countries form the EU does not make it seem the better alternative. However, I am surprised how different the United States and Europe are in their approach and willingness to deal with the current debt crisis.
The current focus of international investors is clearly on the European situation. There is a great deal of urgency to address the debt problems. As a result, a number of governments have been toppled in order to force reforms. The EU now needs to decide whether it wants to become a true political union with a centralized government, in which the influence of individual member nations is reduced further.
The current situation is similar to the United States’ situation between 1777 and 1787 when the 13 former British colonies formed a union (“Articles of Confederation and Perpetual Union”). The various problems with this decentralized setup led to the adoption of the U.S. Constitution, which made all member States part of a single republic with a strong central government. However, even if Europe were to decide to form a closer union, doing so would not guarantee success.
The United States’ situation today looks more stable only at first glance; the truth is that the situation is not much different from the one in Europe. What worries me with the United States’ situation is that not even the Congressional supercommittee has been able to devise a plan to reduce debt, and everything seems to be stuck in a political deadlock. How much longer will international financial markets tolerate this situation? I doubt it will be for very long.