Briefing

The EU Remains Vulnerable to Collapse

Internally, recent elections in Sweden, Austria and Hungary have shown that Eurosceptic sentiment has far from run its course. At the time of writing, the far-right Alternative fur Deutschland has moved into second place in the polls in Germany. The election of a Eurosceptic government in Italy may also yet trigger a huge crisis. More widely, the European Union (EU) remains divided on a range of issues.  Eurozone leaders have tried but failed to agree and fully implement reforms that would put the future stability of the single currency beyond doubt, leaving the whole enterprise dangerously exposed. There are disagreements over how to manage the migration crisis, policy toward Russia, and the future of European defence cooperation.

Externally, the EU faces a hostile and destabilising environment that is far from helpful to its prospects of survival. In the east, Putin’s Russia is using a mixture of illicit financial flows, disinformation campaigns and cyber-attacks to attempt state capture of some eastern European members of the EU. In the south, instability, conflict and people flows present not only a humanitarian challenge but a politically charged migration and refugee crisis and significant security threats.   To the West, President Trump has made clear he is no friend to the EU and has even made diplomatic overtures that would suggest he would prefer it to break-up. He welcomed the Brexit vote, encouraged others to leave immediately afterwards.   In a private meeting with President Macron suggested France leave too, to do a bi-lateral trade deal with the US. He has also tried to stir intra-EU animosity by suggesting that the Union is nothing more than a vehicle for German interests.

Given this wider picture, it is now possible to identify two categories of trigger scenarios that could lead to the EU’s collapse.

The first, which I deal with in this piece, centres on the possibility of a renewed economic crisis and what could be its overall consequences. The second category, to be covered in a forthcoming piece, contains a set of events that are not primarily economic but political and security related in nature.

In the first category, there is now the possibility of either a new financial crisis or a renewed recession, either of which could have major consequences for the stability of the EU.

To take the first, warnings that a further financial crisis may be around the corner are coming thick and fast. There is deep concern about unregulated shadow banking in Asia and about the continued trade in over-complex instruments that prevent financial institutions fully understanding their own risk positions. This is a recipe for irresponsible behaviour and given the level of uncertainty around actual exposure to risk, for a further credit crunch in the event of a crisis. For the EU, this has the potential to create system-level banking crises, especially in a country like Italy, which still has a significant problem with banks laden down with bad debt. Why this might be existential for the EU is returned to in a moment.

A recession, as opposed to a financial crisis, could also act as a trigger to EU collapse. Such a recession could be brought about by the effects of Trump’s protectionist measures and the negative impact they have on EU export markets, not only directly, but as a result of the wider turbulence they bring to global trade. Perhaps more minor, but not insignificant negative impacts on the EU economy, could also come from a no deal Brexit, or from conflict in the Middle East driving up oil prices.

The most obvious path to EU break-up from either or both of these scenarios passes through a new, combined sovereign debt and banking crisis. In the event of Italian banks collapsing in a global financial crisis, for example, the Italian government would need to step in. It already has a very large debt to GDP ratio and would quickly run up against markets unwilling to purchase Italian government debt amid speculation that it would not be able to make good on its borrowing. With EU bail-out mechanisms not designed to deal with a crisis on such a scale, Italy could be driven to the exit door of the euro.

In the event of a recession, the dynamic would work the other way around. Italian government finances would deteriorate, leading to a need to borrow more on the markets. The willingness of investors to lend may not, however, be there. In such a situation, the yield on Italian government bonds would rise and the price of them would collapse. Since Italian banks are large scale holders of those bonds, their balance sheets would take a severe battering and many of them would go under. A bail-out from the cash-strapped government would not be an option and with EU bail-out funds insufficient, the Italian government could, again, be driven to the euro exit door.

This is all a manifestation of the fact that the so-called doom loop between government and bank finances in the eurozone still exists. In stable circumstances, it lies dormant, but the link will be ruthlessly exposed in a crisis.

If a large member state, like Italy, was forced out of the euro by the markets, contagion would spread to other members of the eurozone and others would be likely to follow, one by one. As the single currency unravelled, this would have profound consequences. The TARGET 2 payment system which oils the wheels of intra-Eurozone trade would dry up; a depression would be highly likely; new currencies introduced would depreciate and competitive currency devaluations would be attempted as individual European states sought trade advantage. The response to that would, in return, be the introduction of protectionist measures and non-tariff barriers against other states in Europe. The single market would cease to exist. And as a result, so would the EU.

Despite a lot of noise about reform, nothing fundamental has changed since the euro crisis of 2010-12 to take this kind of further existential crisis for the euro, and the EU, off the table.

The EU’s Banking Union, supposed to break the link between bank and government finances, is not being implemented consistently and effectively. The bail-out funds available to the EU, as noted, are insufficient to deal with a country the size of Italy or, for that matter, Spain, and even if they were large enough, the politics of further national bail outs is politically toxic both in the countries that would do the lending, and in those who would have to engage in further austerity in return for the money. President Macron’s Fiscal Union proposal, which alongside a fully functioning Banking Union, is designed to help make the single currency crisis proof, is going nowhere because the chances of selling its strictures in a country like Italy are non-existent and the Germans are not in favour of it.

The result? The euro and the EU are sitting ducks, hoping the next crisis does not happen.

01.10.2018