The State of the European Union at 60

There have been several recent developments in the European Union which for the most part confirm the trends I had observed in my 2017 Global Economic Outlook. Here I will provide a more detailed and updated analysis of the overall political and economic situation in the European Union.

In a recent White Paper released ahead of today's summit in Rome to celebrate the EU’s 60th anniversary, European Commission head Jean-Claude Junker outlined several possible scenarios for the future of the EU. The possibilities included maintaining the status quo, abandoning multilateral cooperation in areas other than the Single Market, and having either the EU as a whole (as a federal entity) or groups of countries (“coalitions of the willing”) form closer cooperative arrangements in specific policy areas, such as defense, internal security, taxation or social matters.

Yet even before the Rome Summit has taken place, the heads of continental Europe’s four biggest economies (Germany, France, Italy and Spain) strongly endorsed one of those scenarios. Their decision to opt for a multi-speed Europe, in which some countries can integrate faster than others, is going to have far-reaching implications for the European Union. For one thing, it is clear that EU-wide federalism is now as good as dead for the foreseeable future. In all likelihood, the EU will not collapse as many have hastened to predict, yet it will continue to function as a de facto confederation, sometimes even in apparent violation of the existing body of EU law. Yet a Europe of multiple speeds does not preclude the formation of closer quasi-federal entities – either at the core or on the periphery of Europe. The way that the statement of the big four was perceived by many of the citizens of the EU’s periphery countries was that essentially they were being treated as “second-rate” Europeans. This has of course put the cohesiveness of the EU as a whole, and the idea of a European polity, under yet another threat.

Another development which could exacerbate political tensions between the core and the periphery was the recent election of Donald Tusk as the European Council (EC) President. Notably, he was re-elected by the European Council against the will of his own country's government of Poland. Though formally the election of the EC President does not require the agreement of the candidate’s national government, especially in the context of the move to a multi-speed Europe this precedent has made it clear to Poland that in certain matters that are important to it, its voice could not and would not be heard.

Not only is the periphery being essentially disenfranchised, but certain more invasive (for the core countries as much as for the periphery) EU wide policies and practices are being abandoned. One example is the fact that the Acquis (i.e. body of EU law) on migration has not been fully implemented, given the opposition of most Member States in Eastern Europe in the midst of a long-standing controversy on how to redesign EU policy on refugees. Another is that the European Commission announced the decision to discontinue its EU level corruption monitoring mechanism, which used to lead to the publication of anti-corruption reports covering all Member States (including Western Europe). When asked to state why this occurred, the European Commission spokesperson, Margaritis Schinas, stated that “for the Commission, the fight against corruption is not in any way an attempt to interfere or offer value judgments within the political life in a Member State”. Yet at the same time corruption was left as a topic in the separate progress monitoring reports for Bulgaria and Romania, in what was essentially another manifestation of Europe’s double standards and disadvantageous treatment of some of the periphery Member States. This is particularly vexing given the corruption and fraud scandals in France involving senior politicians (namely, the Minister of Interior as well as two of the main presidential candidates) procuring fictive jobs and payments for their closest relatives from the public coffer, or misusing EU funds.

On the other hand though, the perceived insecurity of a US/NATO defense shield given Trump’s coming to power and Russia’s military resurgence are providing a strong impetus for closer defense cooperation at the EU level, and in general for preserving some measure of EU unity in foreign policy. Recent opinion polls suggest rising support for the EU in continental Europe, which was exemplified by the recent victory for PM Rutte, the staunchly pro-EU candidate in the Netherlands’ elections. In France, although Le Pen is leading according to some polls, it is widely expected that she will lose to Macron in the second if not already in the first round of voting. The situation is trickier in Britain, which is threatened by disintegration itself following Brexit. Namely, there are concerns that Scotland will vote for independence from the United Kingdom in a second referendum on the matter that was just recently announced. One problem for Scotland is that the UK government is likely to delay the referendum till after the UK has officially left the EU. This would mean that in order to be allowed back in, Scotland would have to overcome the very likely veto of Spain, itself worried about irredentist scenarios where separatist-minded provinces vote to “exit” Spain while remaining in the EU. In fact, the Spanish PM has also strongly opposed the notion of automatically allowing an independent Scotland in and assuming it can simply take Great Britain’s place in the EU even if it votes for independence prior to Brexit. Moreover, recent polls also suggest rising Euroscepticism in Scotland, an opposing trend to that in continental Europe, which further complicates matters.

Yet by far the most significant threat remains the prospect of – or some would claim already the reality of – an Italian banking crisis, and the possible spillover effects on the rest of the EU economies, first in  Germany and then elsewhere. This threat has not subsided but remains probably the most significant short-term threat to the EU project, the Euro and the global economy.

Since the 2008 crisis, much like Greece, Italy has been plagued by a stagnant economy, underemployment, and per capita income levels still lagging behind pre-crisis levels. The poor health of the Italian economy is reflected in the fact that yield spreads on ten-year Italian bonds have lately increased to over 200 basis points (i.e. 2%) vis-a-vis German bunds. While non-performing loan (NPL) levels are generally not as high as in Greece, the third largest bank in Italy, Monte dei Paschi di Siena (MPS), has NPLs totaling nearly 30 billion USD, which accounts for over a third of the bank’s entire portfolio. The problem in both countries is that their hands are tied as ECB sets key interest rates throughout the Eurozone, so the Italian central bank cannot raise interest rates and thus stem capital flight, or depreciate the currency as Italy now shares the Euro with other countries in the Eurozone. However, since markets require risk premiums for Italian bonds, this leads to reserve losses for the government. Once a EU Member State joins the Eurozone, its reserve losses are automatically handled under Target2, or the Trans-European Automated Real-time Gross Settlement Express Transfer System whereby its central bank borrows to maintain the intra-euro peg. Italy’s Target2 deficit is currently hovering around the precariously high level of 400 billion USD, or slightly above 20% of its $1.85 trillion GDP in 2016, indicating considerable financial stress on the Italian economy and public finances.

Given Monte dei Paschi’s size and Deutsche Bank’s net exposure to Italian financial institutions at close to 2 billion USD (as well as DB’s own unrelated problems), MPS bankruptcy and consequent highly likely contagion and panic in the Eurozone’s financial sector must be avoided at all costs. Since resolving the bank’s situation by resorting to private investments has been unsuccessful, at this stage there are no alternatives to the bank receiving public money.  However, according to recently implemented EU rules, MPS must first be bailed in to the amount of 8% of the bank's assets before it can receive bailout funds. However, by contrast to other Western European countries where bank bonds are mostly held by institutions, in Italy bonds are mostly held by retail investors and a bail-in haircut would wipe out their savings and cause wide-spread political instability, which in turn could lead to the election of the Eurosceptic Five-Star Movement in snap elections and ultimately Italexit. Therefore, chances are good for the newly proposed plan for MPS to sell its bad loans portfolio at 25% of face value to a newly created “bad bank”, and then receive up to 9 billion Euros of state aid to repair its balance sheet. European Commission approval is still necessary and the plan is currently under consideration by EU authorities.  

In this context, it is interesting that Germany has been bringing gold back home from the vaults of the New York Federal reserves as well as from Paris. Since 2013, Germany has transferred over 600 tons of gold to Frankfurt. The official excuse is that the country no longer has any fears that the Soviet Union (or Russia nowadays) would invade and take over its gold as was feared in the Cold War days, while being part of the Eurozone, Germany need not keep any gold reserves in other EU Member States capitals for the purpose of facilitating emergency currency exchanges. Yet it appears that another significant reason for Germany’s actions are concerns about maintaining public trust in the Euro in the midst of Italy’s impending banking crisis (not to mention concerns about Germany’s own potentially significant problems if Deutsche Bank implodes). It is also the opinion of this author that the decision to favor a multi-speed Europe over the other Junker scenarios for Europe’s future also stems partially from similar concerns. Namely, in a more flexible multi-speed Europe, it will be much easier for Germany to step in and rescue Italy’s banking sector if it becomes necessary in an emergency setting, without having to concern itself with the need to pay other Member States’ bills too.