For now, everyone has their eyes on Europe’s energy crisis. And we’re all wondering what it means for us. Booming Aussie gas and uranium stocks? Or an energy price shock to the local economy too?
But I believe there’s something far more dangerous brewing in Europe, which will have much bigger implications for Australian investors than spiking energy costs. And, next month, it’ll boil over into financial markets, burning a lot of very surprised little fingers.
My book, How the Euro Dies, concludes that the euro makes no economic sense, but ending it is purely a political decision, not an eventual economic cul-de-sac.
That’s because the insidious effects of sharing a currency don’t lead to a dead end but a gradual worsening of economic conditions. At some point, people will vote to end the self-inflicted pain, or their leaders will be forced to do so in order to get re-elected.
It’s the same for all currency pegs, really. They eventually run their course, with the economic side effects growing too painful to ignore. Politicians and policymakers decide to end the silly idea.
The pound experienced it in 1992, and the UK took that embarrassing experience as a warning to avoid the euro. Several Asian countries experienced it during the Asian Financial Crisis. And Australia opted for its own currency for a reason too.
Then again, leaving the UK pound unleashed economic chaos for Australia, right? So I can’t imagine why any Europeans would want to…
But it’s not the inevitable end of common currencies that I want to focus on today. Nor the horrific fallout it really would cause this time. Instead, consider whether that end may be…beginning.
If you accept that leaving the euro is ultimately a political decision, you also see why watching European politics is crucial for those who believe the euro is inherently flawed. It will reveal when the next European sovereign debt crisis will begin earlier than other (economic) indicators.
Now, European politics is entertaining at the worst of times. But cue Poland’s foreign minister arguing that countries should be allowed to leave the euro. His reasoning was about economic development and the costs of sharing a currency.
But the Poles are not the point. It’s the Italians I’m worried about.
The Italians will vote for a new government on 25 September after another coalition led by a technocrat failed.
What makes things interesting is that this time, the coalition government will likely be made up of the right-wing parties led by the far-right. All are eurosceptic to some degree, but this time, they’ll be much more coherent than the bizarre coalitions of the past.
Why are Italians turning to extremes?
Italian GDP per capita is lower than when the euro was introduced…
While the rest of Europe’s economies have been through booms and busts, Italy’s has simply been left behind.
People in Italy understand that the euro’s stranglehold is a key part of this divergence. Monetary policy is constantly being set for the Germans or the French. The exchange rate reflects the prospects of other nations too. And Italy’s ability to reform its economy to adjust for this simply doesn’t exist.
This needn’t portend the end of the euro, though. Elections have happened in Italy (rather often), and the decline of Italian GDP isn’t new either.
The combination of inflation, debt, and economic stagnation in the eurozone makes the present situation so dangerous. You need all three to make things come to a head badly enough that even politicians can’t ignore them any longer.
That’s because the Italians use shifty monetary policy to solve their debt and GDP problems, while the Germans are not — especially not when inflation is high.
It’s hard to set one monetary policy for Australia or the UK. But the US Federal Reserve and European Central Bank have to set monetary policy for many nations.
In the US, the Fed is only politically accountable to the local population, despite controlling the global reserve currency.
The Europeans have a much tougher task. One monetary policy for a long list of nations facing different levels of inflation, unemployment, and, crucially for today, sovereign debt. They also have very different perceptions of what ‘high’ and ‘low’ is for those figures. And they collect the statistics a little differently.
Another point is that the same monetary policy change has very different effects in different parts of the eurozone because of these differences.
In Germany, a rate hike might reduce inflation, but in Italy, it could trigger a sovereign debt crisis…
Crucially, setting policy in the no-man’s-land in-between only worsens the economic consequences. It fuels German inflation and drags out Italy’s slow-motion sovereign debt crisis.
Patience is running out on both sides with this policy.
The present bout of inflation has cornered the ECB. It’s now forced to choose between allowing inflation in Germany to run hot, or to bankrupt Italy and others with interest rate hikes.
Inflation has triggered the decision because, until now, the ECB had an excuse for constantly bailing out Italy in backdoor ways: it was only trying to get inflation up a little, that’s all.
That excuse is now gone. Any continued financing of Italy no longer has legal cover under high inflation.
German electricity prices surged 25% in a single day on Monday…to 14 times the average level. And producer price inflation is at 37%…
In Italy, ever more extreme governments are getting elected each time around.
Something has to give. And the only option that allows each country to deal with its own unique situation is to give them back their monetary policy and exchange rate by leaving the euro.
Another key change for the Italians is one that happened nearby. Now that Brexit has proven viable and beneficial to the UK, the debate in Italy has fundamentally changed. Leaving is — or at the very least appears to be — plausible.
It’s not like Italy hasn’t crashed out of European currencies before. It’s practically a tradition for Italy and Greece to do so.
I suspect returning to their currency would be good for Italy surprisingly quickly. But the rest of the world would be in deep trouble because of the default this would likely accompany.
What I want to warn you about today is a rerun of the 2018 crisis, which, at the time, delivered the worst period for financial markets since 2008. It only ended because the ECB was able to rescue Italy thanks to low inflation.
What will a European Sovereign Debt Crisis with inflation look like? I think we’re going to find that it’ll involve the end of the eurozone.
As Otmar Issing, the ECB’s first chief economist and a crucial player in the euro’s creation, made clear, ‘one day, the house of cards will collapse’.
The Italian election may turn the game of building a house of cards into a game of Jenga. And it’s Italy’s turn to have a tug.
Until next time,
Editor, The Daily Reckoning Australia Weekend