Drawing on his expertise on financial markets, Fernando Primo de Rivera in this contribution for United Europe gives a very interesting view of the euro crisis. Thanks to the structural reforms it was forced into, Spain is coming out of the crisis much stronger than it was before. The year 2017 offers Europe a unique opportunity if populist movements can be kept at bay in the coming elections in the Netherlands, France, Germany and possibly Italy.  If Europe manages to get its act together, it could exercise genuine and legitimate global leadership in the defense of the international liberal order.

Fernando Primo de Rivera, CEO and Chief Investment Officer at Armada Capital

Europe at a cross road

Under Anglo-Saxon leadership, the liberal free order has underpinned globalisation for the past 70 years. Now, however, with Brexit and the election of U.S. President Donald Trump, this process is stalling. At the same time, the European Union and more precisely the eurozone constituency,  will need an architectural re-design as the electoral cycle of 2017 is completed.

From outside, the EU is facing mounting pressures from some of its allies defecting to Russia’s President Vladimir Putin, from China and from immigration. This critically coincides with an incomplete integration process which has stopped just short of a real fiscal and political Union. All EU countries have been shouldering massive efforts towards convergence and compromise, but further progress requires bold political action. There can be no giving in to “alternative facts”: that a monetary union can survive without a fiscal and political Union.

Never in EU history have both risks and opportunities been so clear. The elections in key European countries in 2017 will likely prove that populism can be kept at bay for now. Yet the European Central Bank will have exhausted its non-orthodox monetary tools by the end of this year. This means that going into 2018, the euro zone political constituency cannot risk another cyclical downturn. There is little time to procrastinate.

Origins and nature of the euro crisis

When in October 2010, Chancellor Angela Merkel and then French president Nicolas Sarkozy met in Deauville to discuss the Greek situation, they may not have realized the magnitude and nature of the crisis that was about to break out.  The global debt crisis, bred through too little regulatory oversight, had shaken up the US mortgage and structured products markets two years earlier. Now, it was about to morph into Europe’s sovereign debt crisis.

EU member states not only had a very different debt stock, but their growth profiles –central to serving that debt – also differed substantially. Nevertheless, the European treaties did not allow for cross country bail-outs, and the ECB pursued a single mandate around price stability. This made for an explosive cocktail.

From the Greek epicenter, the debt crisis spread out across the continent, running up the chain of economically and financially weaker euro members in the periphery: Ireland, Portugal, Spain and Italy. Slowly but relentlessly, the cost of funding rose. These countries didn’t start out with a fiscal problem in their public finances, but sky-rocketing funding costs soon led to unsustainable budget structures.

Thus, the spark fired by Greece’s chaos transformed an overall debt crisis underpinned by current account imbalances into a full-fledged sovereign debt crisis. It is no coincidence that the countries with current account surpluses – due to better productivity and competitiveness – became the main creditors. For these countries, the euro meant a nominal reduction in prices relative to what would have been warranted by a national currency.

Financial markets fragmentation, the widening gap in funding costs between the northern creditor countries and the debtor periphery, had started. Creditor banks started off an exodus of capital from peripheral exposure which became self-fulfilling. The funding costs for Ireland and Portugal reached levels that rendered public finances unsustainable. In 2011, both countries had to be put under financial surveillance and assistance programmes crafted by the European Commission and the ECB. It was Europe coming between these countries and the markets.

At the end of 2011, and coincidental with a change at the helm of the ECB from Jean-Claude Trichet to Mario Draghi, the Italian Prime Minister Silvio Berlusconi had to resign, unable to withstand market pressures that called for reform and adjustment. Immediately after, Draghi put forward LTROs, unlimited funding lines for banks. While this allowed for a brief breather, it inadvertently also strengthened the nexus between sovereign debt and local financial systems. As a consequence, the fragmentation of European markets increased.

Against the odds: an imperfect diagnose was followed by a fairly successful treatment – except in Greece   

How many times during those months did EU ministers meet until the early morning hours in the Justius Lipsius palace in Brussels! In the face of extreme urgency, new and complex legal decisions were crafted every week. Yet beyond financial markets professionals and high-ranking politicians, few people understood the existential nature of the euro crisis and its potential to wreak havoc on Europe and global financial stability.

Merkel’s stealth and nerve were paradigmatic. She could have chosen the easy way and endorsed a common risk sharing liability which, at the time, could have proven the kiss of death for Europe. Instead, she focused on sustainability and promoted the European Fiscal Compact which was signed by all EU members except the Czech Republic and the UK in March 2012. This agreement outlines the need for containing debt and public deficits country after country. It was indeed the first time that EU members aligned onto the same page in order to restore long termcredibility.

Facing ruthless markets and weak governments, new crisis institutions were crafted with the ESFS later being integrated into the ESM, around the pillars of solidarity and conditionality.  But it was the ECB President Draghi’s historical “whatever it takes” statement in late July 2012, coming after a 100 billion-euro assistance line for Spanish banks in May, that finally did the trick.

Markets took the central bank’s statement at face value, and fragmentation trends started reverting. In parallel, assistance programmes on the basis of three major points were put in motion: debt and public deficit targets, internal devaluations to align labour costs to productivity, and reformist agendas aimed at freeing market forces from red tape and political short term interests.  The model was  Germany’s “ordo-liberalism” with its success of combining market forces with strong state intervention.

If there is one single principle that was sustained throughout the euro crisis, beyond each country’s proclivity to save or consume, its cultural limitations and other features of diversity, it is the rule of law. With the exception of private creditors in Greece, the EU maintained the principle to honor debts. To this, all of Europe signed up, foregoing what in earlier history had been a customary method to resolve sovereign debt crises: outright write-offs.

This was the right way to go – in so far as the imperfection of the solution was acknowledged. Ultimately, the directives based on conditionality, debt containment and competitiveness will prove to be key to Europe’s survival into the XXI century. But to consider that the divergent patterns of competitiveness opened up by the euro are not structural or that the measures to correct those are sustainable into the long term is “magic thinking”. Ultimately, competitiveness should be sought at a European level and the process to converge upwards within is inherently limited. This is what it is about when Merkel speaks of the euro as a “political project.”

Against the warning of many political and economic commentators, the deflationary pressures resulting from the policies implemented across the periphery were not offset by inflationary practices via fiscal means or wage policy in the north. Partly thanks to quantitative easing, the unorthodox monetary policy that the ECB started implementing in 2015, growth resumed in those countries which had embraced the genuine need to reform, notably Spain and Ireland. Those that flirted with pseudo populist political positions, Portugal and Greece, either stalled or in the latter case with Syriza, regressed from an initial good start.

Within the periphery, Spain has set an example that refutes the naysayers.  When president Mariano Rajoy took over the government, the imbalances were enormous: the public deficit was reaching 9% percent, and the current account deficit almost 7% percent of GDP. After five years and a long ride of banking deleveraging, the public deficit has been reduced to 3% while the current account shows a 2% surplus.

What is most important, however, is that thanks mostly to the labor market reform, exports have grown from 20% to 32% of GDP. This is a turnaround that will be closely studied in economic history books: Spain has effectively repositioned its entire economy to be able to compete overseas. Much else needs to be done but the paradigm blessing the core of supply side measures has been set.

Of course, there are still people who deny that the euro can survive. They argue that the Italian economy has been growing by a negligible 0.5% per year since it joined the Euro because it was deprived of its former perennial recourse to devalue the lira. Yet the Spanish example proves them wrong. If Spain can do it, Italy should be able to, as well.

Italy’s creativity needs to be freed up from the connivance of political, financial and judicial instances. The country needs a broad package of reforms that privilege long term public interest over the short term entrenched egoism. Lead by Matteo Renzi, the catharsis did indeed start but now remains stalled. Early elections, if they happen this year, may finally open the way to reforms. Italy needs to use its membership in the euro to push for more convergence in terms of economic and political governance.

Work in progress: dispelling “alternative facts” and seizing opportunities

Due to the crisis, the euro has turned into a real identity symbol and into an instrument of convergence towards the best standards of economic and political governance. However, historically no monetary union has ever worked if was not backed by a political union. The EU,

under its current architectural design, does not have a genuine fiscal union. This is why financial markets have been suspicious ever since the crisis started. They hear the political discourse but do not quite believe that Europe will be willing to back its words with deeds.

2017 brings elections in the Netherlands, France, Germany and possibly Italy, opening up new opportunities. In all likelihood, populism will be defeated, and all four countries may find themselves in a much better position to debate and bring forward new stages of European political integration.

The current limits of integration with an imperfect banking union (SSM, BRD, etc) and a fiscal union still in the design stage have been well profiled in various Commission and ECB papers. Yet the reform proposals have been put in the drawer until the electoral cycle is completed. But Europe ought not believe in its own “alternative fact”: that a monetary union is workable in the long run without risk sharing and common liability, no matter what short sighted political interests might demand.

Europe is at crossroad, and the choice is binary. It is no coincidence that the to-do lists for fiscal integration contain proposals for a common deposit insurance scheme for the banking union and a common unemployment figure in labour markets. Indeed, integration has stopped just short of areas which could be seen as a fiscal union.

Fortunately enough, the EU is likely to survive the current electoral cycle. Yet the odds are that it will not withstand another crisis in its current format. In the tension between what is economically desirable and politically feasible, left wing populism in the periphery is growing even faster than right wing populism in creditor countries. In truth, the latter was actually focused more on Islamic immigration made possible by a well principled but poorly executed open door policy to refugees than on yet another attempt to solve the Greek debt crisis.  Given the internal crisis and the state of global affairs, countries simply cannot go it alone anymore.

We will have to have a debate on “risk sharing”. It was silenced for too long by politically convenient, short term narratives. But it should not overshadow the historical magnitude of the opportunity lying ahead for a politically unified Europe.

We know – and since Trump’s election are willing to say so openly – that the euro crisis is Europe’s problem and Europe’s problem only. The euro zone has a 2.5% current account surplus vis-à-vis the rest of the world. This means we have no need for external funding. In aggregate, Europe shows the best public finance records in the developed world. It boasts a welfare system that – despite a permanent need to make it fitter – will act as a cushion against “inequality” and rampant populism.

Overcoming the short sighted national interests, Europe will be the necessary counterweight to the free-ride globalisation model that has backfired on Anglo-Saxon political constituencies.  Its features are a healthy skepticism towards financial largesse, or the genuine value put on institutional and jurisdictional frameworks and principles, or the best-in-class commitment to the international rule of law when addressing  global affairs from climate to international trade.

We will need to start a debate about risk sharing and fiscal mechanisms to recycle northern creditor current account surpluses into deficit countries – by private or by public means, or by a mixture of the two. No other outcome allows for an optimal economic policy management. Germany’s 8% current account surplus is a sympton of structural European policy disfunction, a sign of utter disorder.

For far too long, nobody has dared speak about this. Yet these elements only need to be supported by a proper message in order to get the necessary political backing. And if, at some point in the future, Europe manages to build a proper fiscal and political Union, it could become possible for the euro to outrank the dollar as world’s most important reserve currency with all the privileges that that brings about.

The political events that happened in the Anglo-Saxon world in 2016 and the drift towards populist propositions offer Europe a unique opportunity. Getting its act together, it would exercise genuine and legitimate global leadership in the defense of the international liberal order. It would also capitalise on its own “raison d’etre”: the overcoming of tribal, sectarian, nationalist interests , which the rest of the world is in desperate need of.

Elections in 2017 and their aftermath represent for Europe a once-in-a-lifetime opportunity to revisit the costs and benefits of moving ahead and transform what is still a political dwarf into a Phoenix.  In the very end, after such twists of history, the legacy of the founding fathers of our enlightenment, from Voltaire to Kant, from Hegel to Rolland, needs only to get dusted off and be honoured in earnest.

Fernando Primo de Rivera is CEO and Chief Investment Officer of Armada Capital in Madrid and a member of United Europe.