The Covid-clouds might now be clearing from the European economic landscape. However, as they dissipate, they reveal just how uncompetitive much of the euro area has become. Labour markets are as inflexible as ever; structural unemployment is high; debt burdens are enormous.

But, because they share a currency in the euro, devaluation is not an option for the nations that need it.

With devaluation off the table, the only reason why the weaker euro area members haven’t already defaulted instead is because the European Central Bank (ECB) has implemented one emergency funding facility after another.

Thus it may seem curious that borrowing costs for those weaker euro area member countries, such as Spain, Portugal, Greece and Italy, remain so low – negative even.

Why are financial markets so complacent? Well, with the ECB now the buyer not only of last but even first resort, there isn’t a real market for their bonds.

However, central banks, including the ECB, can’t print prosperity and growth. They can only buy time, and at a cost.

And so, recently I revisited some research that I first did in the mid-2000s, when I sought to estimate the probability that one or more euro area member countries would choose to withdraw and reintroduce their national currencies.

In 2006, while in charge of European Fixed Income Strategy for Lehman Brothers, my investigation led me to recommend that investors sell short Italian and Spanish government bonds versus German Bunds.

At the time, spreads between these bonds were a mere 0.2% or so, the narrowest ever. This implied a mere single-digit percentage chance that the euro area would be struck by a major financial crisis in the coming years.

How could I know that? Well, as part of my research on the topic, I studied the long-term history of economic convergence between the so-called “peripheral” euro member countries, including both Italy and Spain, and the so-called “core”, centred around Germany. These categorisations were widely used to distinguish between those euro member countries that had traditionally had relatively weak currencies, subject to periodic devaluations, and those whose currencies had tended to remain relatively strong.

During the 1990s, in the run-up to the Economic and Monetary Union (EMU – the replacement of national currencies with the euro), there had been a significant amount of convergence. Under intense political pressure, the peripheral economies tightened their budgets and placed pressure on their domestic labour unions, public and private, to keep wage demands relatively low. The goal was to meet the so-called “Maastricht criteria” explicitly laid out in the 1992 European Treaty that paved the way to the adoption of the euro.

While there were some bumps along the road, in particularly the crises of 1995 and 1998, the political pressure paid dividends. Unit labour costs in the periphery converged towards those in the core, showing improved economic competitiveness. Government deficits shrank, as did their historically accumulated debt burdens.

Although it was a close-run thing in the end, even Greece managed to qualify for euro membership by 2002 (two years late). What really mattered at that point was that all seemed to be going smoothly with the euro’s introduction: that was the moment where financial markets lost interest in the convergence theme.

Whereas markets might have lost interest, I kept a keen eye on the relative performance of the euro area economies. And by the mid-2000s, it became apparent that the prior convergence, between the euro periphery and core, had gone into reverse.

This increased the risk that, over the coming years, the euro area would break up. The less competitive economies would face pressure to devalue. Yet unable to do so within the euro, they would face mounting political pressure to outright withdraw from EMU.

In practice, that would mean that they would reintroduce their old currencies and then devalue those currencies so as to restore competitiveness to more-or-less where it had been prior to those economies’ joining the euro in the first place.

By my calculations, that would have required devaluations on the order 15-20%, probably even more, to compensate investors for the possibility that another devaluation might take place again in future. By taking the further step of applying some bond mathematics, I was able to calculate that the market-implied probability of the peripheral countries leaving EMU and devaluing was minimal: this was why I recommended from mid-2006 for investors to reduce or close their positions in Italian and Spanish bonds.

As it happened, the 2008 global financial crisis was just around the corner. It may have begun in the United States, but it rapidly crossed the Atlantic. Euro-area bond spreads widened as there was essentially no bid for Italian, Spanish or other peripheral euro area debt. The ECB had to come to the rescue with emergency lending programmes. Formal sovereign debt restructurings subsequently took place, with Berlin, Brussels and Paris largely dictating terms.

In the most severe case, that of Greece, bank accounts were essentially frozen. Withdrawals were limited and de facto capital controls were imposed on Greek residents. Debt relief became conditional on the implementation of unpopular government austerity programmes.

Greek Finance Minister Yanis Varoufakis reportedly worked on plans for Greece to exit the euro, but his efforts were overwhelmed by decisions made elsewhere, including at the ECB. The lesson was clear: other euro area members that refused to do as they were told would suffer a similar fate.

Why did it have to come to that? Well, in brief, there is no free lunch in economics.

The euro shifted risk, but didn’t reduce it

The euro may have removed the perennial devaluation risk for the weaker legacy currencies, such as the lira, peseta and drachma, but it is not a magic wand that simply made economic risk disappear altogether.

Bad economic policy is bad economic policy. It is unsustainable. In time, the financial markets pounce. And if they can’t pounce on a national currency, they pounce on the national debt instead, and that of the banks.

Almost from the moment the euro was introduced, Italy, Spain, Greece and other peripheral countries that had tightened their belts and budgets in order to qualify for EMU began to lose competitiveness vis-à-vis Germany. The windfall of lower interest rates went into property and other forms of speculation.

By the time the 2008 crisis struck, Italian and Spanish labour costs had risen some 15-20% relative to those in Germany and Italian and Spanish banks were sitting on large piles of non-performing loans.

When the ECB stepped in to stop the carnage in the bond market, its balance sheet exploded in size. And, as the balance sheet expanded, it became heavily and disproportionately laden with Italian, Spanish, Greek, Portuguese and Irish debt. Today, over a decade later, the ECB balance sheet continues to grow. Meanwhile, there is still no real free market in peripheral euro debt. The ECB is the only buyer. The value of the debt is basically whatever the ECB says it is.

Thus, investors cannot expect the growing imbalances inside the eurozone to show up in spiking bond spreads any more. But they’ll show up elsewhere instead. And tomorrow, I’ll show you where…

John Butler
Author, The Golden Revolution, Revisited