Much of southern Europe is insolvent

We pleaded in May that the dollar would fall, and it fell. Basically, the United States was the last part of the developed world where rates hadn’t fallen to zero, but the pandemic has changed that.

This created a situation where the Fed could pull out all the caps in terms of unprecedented policy response (supporting any market in sight) while the ECB had to be more circumspect as it is more divided.

The outcome was still likely to lead to EUR/USD being a bit of a one-way bet:

But don’t bet on the strength of the euro to last, even if it will last for a while.

Dysfunctional euro

In a way, this relative strength of the euro is rather ironic (and unnecessary). It is not that the euro is a beacon of stability, far from it. In fact, the whole monetary union in its current form is untenable.

It’s not just us saying that, it’s Klaas Knot (in Dutch we are afraid..), the president of the DNB, the Dutch central bank. Where we differ is in solutions, not diagnosis.

Here’s the thing, Italy, Greece and in all likelihood also Portugal and Spain are basically bankrupt. Deprived of the means to revive their economies and print their own currency, they are once again sitting ducks.

The euro is bad at managing economic shocks that are asymmetric, ie that affect some countries more than others. And the impact of the coronavirus has created such a situation:

  • Countries like Italy, Spain, Portugal and Greece are much more dependent on tourism, so their economies and jobs are hit harder by the pandemic.
  • These countries do not have the budgetary means to react as, for example, Germany has (the package is equivalent to 30% of GDP in total), with massive economic rescue plans.

If the euro did not exist, what would happen in the event of such an asymmetric shock is that the currencies of the most affected countries would collapse, automatically inflating their economies.

These countries would also have their own central banks, which could print money at will, finance a major state effort to prevent businesses and families from collapsing, and invest in the future when the end of the pandemic is in sight.

In a well-functioning monetary union, there would be an alternative to these adjustment mechanisms in the form of a big central budget, which automatically redistributes from the stronger countries to the hardest hit countries.

This happens automatically in the United States, where the federal budget receives less from the hardest hit states but pays out more, an automatic redistribution.

Since the Eurozone does not have a large central budget, any comparable redistribution must be done by a deliberate political act, which makes it visible and this leads to a violent reaction in the paying countries, which will shout “transfer union”. , as we have seen .

Wealthier countries fear having to permanently subsidize weaker members and fear that this subsidy will weaken the incentives to reform their economies. These fears are justified, but they are only half true because they relate only to the cost of monetary union, not to its advantages.

Without monetary union, the stronger countries would have experienced much stronger currencies, which would have hampered their competitiveness and their tradable goods sector.

This can be seen in the huge trade surpluses enjoyed by Germany and the Netherlands, and this in itself prolongs the asymmetric impact of the crisis, as costs are misaligned within the eurozone.

The ECB as buyer of last resort

With the 750 billion euros only coming into force in the middle of next year, then gradually and equal to around 0.7% of GDP per year (for Italy), this is not clearly not enough to make a big difference for member countries like Italy which are in an epic streak. tightening of public finances with debt/GDP spiraling upwards.

It is therefore incumbent on the ECB to absorb all this Italian debt and prevent rates from skyrocketing, which would immediately trigger a crisis. By the time they stop (or even slow down), the area is in trouble.

Can this last? In principle, yes, but it is a political question. With budget deficits of 10% of GDP and a debt to GDP ratio above 150%, the financing needs are huge, it is hard to imagine private investors stepping in until there is at least the prospect of a significant improvement on the horizon.

It’s probably not that soon. As we explained earlier, Italy did not even manage to reduce its debt to GDP ratio during the good years, it will only increase during the bad ones.

With each click, the problem becomes that much more intractable, which simply forces the hand of the ECB to stretch (or, as some claim, ignore) the rules of its engagement and continue buying disproportionate amounts of debt. Italian.

For Italy’s debt to become sustainable while remaining a member of the Eurozone, Italy needs to experience some sort of economic recovery that hasn’t happened in two decades and the Eurozone lockdown is making that more difficult.

It is true that deep structural reforms could, in time, increase Italy’s growth rate, but this is far from being a magic bullet and risks aggravating the slump in the initial stages.

Italy can’t even inflate debt (which most Western countries did with the hangover of World War II) because it doesn’t have the tools to do it, and even if it had In fact, inflation would further destroy its competitiveness within the euro zone .

As it happens, even the ECB’s monetary stimulus doesn’t really affect Italy, as most of it escapes in the form of capital flight, essentially draining the country of liquidity.

Compare this to a situation in which the country would have its own currency. Capital flight would lead to depreciation, which energizes the market sector and the money can never really leave the country.


This capital flight from the periphery is reflected in the Eurozone Target 2 balances, which reflect the net creditor or debit position of interbank settlement obligations. Here is Italy’s Target 2 balance (ceicdata):

line chart of Italy IT: TARGET 2 Balance: Average from June 2015 to June 2020

Here is the one from Spain:

line chart of Spain ES: TARGET 2 Balance: Average from June 2015 to June 2020

And here is that of Germany:

line graph of Germany FROM: TARGET 2 Balance: Average from June 2015 to June 2020

Most of these developments do not really represent capital flight as such, but are a direct consequence of the ECB’s asset purchase programmes, more particularly when the national central banks buy domestic paper in return for foreign holder (whose mechanism are explained in detail here).

It’s still a bit complicated, here is Mario Draghi, when he was still President of the ECB (Reuters):

Any country leaving the euro zone would have to settle its claims or debts with the bloc’s payment system before cutting ties, European Central Bank President Mario Draghi has said.

This implies that the more the ECB continues to buy Italian debt, the higher its Target2 deficit will be and the bigger the bill will be in the event of an exit from the euro zone.

In Germany, these developments are causing considerable consternation. Germany’s high court in Karlsruhe had ruled that the ECB had abused its power with the earlier bond-buying program and had called on the ECB to explain.

This has now happened and the court has been temporarily appeased by Christine Lagarde’s explanation that the ECB’s QE actions are proportionate to the crisis facing the Eurozone. But for how long ?

It’s not that hard to figure out, in this case. The ECB’s emergency bond buying program is expected to end when the emergency ends, i.e. when there is an economic recovery, which could very well happen next year. next.

The unprecedented economic crisis, after all, is what gives the ECB cover for its unprecedented bond-buying program (in complete disregard of the capital key that says it must buy all countries according to the national ratio of paid-in capital to the ECB).

But an economic recovery, when it does come, will not suddenly put Italy’s public finances back on a sustainable footing. Italy and Greece, and most likely Portugal and Spain as well, will need years of bond buying before they can return to the markets and borrow on near-sustainable terms.

In this light, the strength of the euro can only be temporary, and the paradox is that it will dissipate when the economic recovery of the euro zone arrives.


The Eurozone has been hit harder economically than the United States, but somewhat counterintuitively, this has led to dollar weakness. Behind the facade of the euro, much of southern Europe is fundamentally insolvent, with the ECB being the buyer of last resort for their bonds.

This will run into trouble when the Eurozone recovers economically, as it makes the ECB’s disproportionate buying of Southern European bonds much more unsustainable.

So, just as the relative strength of the United States led to the weakness of the dollar, once again counterintuitively, the economic recovery in the euro zone will end the strength of the euro.

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