[Ed Note: The following is an excerpt from my book How the Euro Dies, which I’ve decided to republish here in anticipation of a return to the European sovereign debt crisis of 2012 and 2018. Be sure to check out Part 1 here.]
If you want to understand why the euro will inescapably fail eventually, you need to know about the Unholy Trinity.
In more politically correct textbooks, it’s also known as the Impossible Trinity and the Trilemma. And they call it that for a reason. It’s an impossible three-way dilemma. It can’t last – something has to give. And that’s when you get a crisis.
Unfortunately, the entire eurozone is built on a violation of this simple economic law. And that’s why it was doomed from the beginning.
The result will be a global banking crisis thanks to rapid contagion, tumbling asset prices across the board, and the destruction of the euro. The Unholy Trinity says it has to happen eventually. But what is this fatal flaw of the eurozone?
The basic idea is that a country cannot have all three of the following at once: a fixed exchange rate, independent monetary policy and free capital flows. (Capital flows are transfers of money in and out of a country.)
One of those three has to act as an economic pressure valve. Otherwise, there will be an economic crisis.
History is full of the economic wreckages of countries who tried to violate this economic law. Just about every sovereign debt crisis can be explained in terms of the Unholy Trinity.
A country attempts to fix exchange rates, control monetary policy and allow freely flowing capital across its borders, all at the same time. Eventually, faced with a resulting economic crisis, it is forced to abandon at least one of the three. Britain did in 1992 and repeatedly in the 70s, when it gave up fixed exchange rates. The pound’s plunge was the opened pressure valve whistling each time.
Britain’s miserable experience with the Unholy Trinity is one reason the country evaded the eurozone in the first place. As I’ve mentioned, Brits used to call the ERM the Eternal Recession Machine. And for good reason, which we’ll get to in a second.
The Unholy Trinity also applies to currency unions like the eurozone. They make things more complicated, but the idea is much the same. That’s why Europe’s many currency unions of the past all failed. Including those in the run-up to the euro.
Here’s how the foundation of the eurozone is built on a bizarre violation of the Unholy Trinity:
- Fixed exchange rates between member countries thanks to the euro.
- A messy, semi-independent monetary policy for the eurozone through the European Central Bank (ECB).
- Free capital flows between countries, which means money can flood into or flee from parts of Europe, as well as international capital flows into and out of the eurozone itself.
The Unholy Trinity predicts that at least one of these three policies will fail. Countries will abandon the euro’s fixed exchange rate and return to their own currency, or capital flight will see money leave southern Europe for the north, triggering a banking or sovereign debt crisis, or countries will seek to regain control of their monetary policy… by leaving the euro.
I’m expecting all three.
The Unholy Trinity is back in the news because eurozone countries are seeing inflation rates diverge. They are increasingly desperate for monetary policy that is actually appropriate to their own national economy. But they can’t have it – not under the euro.
At the moment, the ECB is busily making monetary policy for parts of the eurozone which need the central bank’s support.
But in some parts of Europe inflation is already in the double digits, or approaching those levels. The idea that Germany would have negative interest rates and 8% inflation is mortifying to its people.
But incorrect monetary policy is nothing new to Europe. Some nations have always abused the printing press to get out of trouble.
Back then, the safety valve was the exchange rate. If the Italians or the Greeks didn’t control their fiscal deficits and their central banks were forced to bail them out, then the lira and the drachma would fall.
But that can’t happen today. Germany, Greece and Italy are all on the same euro, with the same exchange rates. And so the problems persist, or grow.
Thanks to inflation, the game may finally be up. The ECB will be forced to choose between prioritising inflation in Germany and the Netherlands or supporting the overindebted governments like Italy and Greece. It can no longer do both.
Which will the ECB choose?
Well, it recently missed another opportunity to actually raise rates. With inflation above 8% in the eurozone, interest rates remain at -0.5%.
The bond market is already on the move, however. Italian bond yields are soaring towards the levels that triggered a crisis in 2018, for example.
Despite a lack of interest-rate hikes, the ECB is withdrawing bond purchases and the market is likely panicking about the prospect of Italy having to finance its own deficit, rather than looking to ECB funding, however indirect that might be.
So inflation is about to force the ECB to expose which European governments can stand on their own two feet and which cannot. The Unholy Trinity will take the furthest back. Or inflation will have to be allowed to get worse.
Editor, Fortune & Freedom