Submitted by Taps Coogan on the 5th of June 2017 to The Sounding Line.

The EU and the Eurozone face a single existential question: will they move toward a federalized system where member countries act more like states found within the US, or will the Eurozone decentralize and return to a simple free trade and common defense union?

There is near unanimous agreement amongst economists and geopolitical analysts that the Eurozone cannot continue in its present form. We have discussed the fundamental problems that plague the Eurozone in one of the very first articles posted here at The Sounding Line. Since then, these structural problems have continued to exacerbate the growing divergence and resentment between the Eurozone economies.

Two fundamental issues are at the heart of the Eurozone’s structural problems.

The first is the lack of coordination between monetary and fiscal policy. Monetary policy refers to actions taken by central banks with regard to interest rates, currency, and quantitative easing programs. Fiscal policy, on the other hand, refers to tax, spending, and regulatory policy originating from politically elected governments. Monetary and fiscal policies are the two main tools available to policy makers seeking to promote economic health and development in a country and proper economic functioning requires synergy between the two. In nearly all countries, monetary policy and the bulk of fiscal policy are developed at the federal or central government level. This allows for the synchronization of the two policies. At a minimum, it allows for monetary policy to accommodate a single fiscal policy. In the Eurozone this is not the case. The European Central Bank (ECB) sets a single monetary policy for all countries in the Eurozone, yet each country abides by its own fiscal policies. Germany and Italy share the same currency and are subject to the same interest rate programs from the ECB, yet they have fundamentally different tax structures, labor systems, and levels of government spending.

Given the huge divergence in economic realities between Eurozone countries, a ‘one size fits all’ monetary policy is futile, especially one that is out of sync with individual fiscal policies. Nonetheless, that is how the Eurozone currently operates.

The second fundamental issue with the construction of the Eurozone is the lack of a consolidated Eurozone debt instrument analogous to US Treasuries.  Virtually all countries outside the Eurozone have a single central government debt instrument (sovereign debt). In the US, like most countries, the central government debt instrument (US Treasuries) is the critical instrument underpinning its bank reserves, interest rates, and the entire financial system. It provides the lowest risk, benchmark, reserve quality financial asset. Each individual US state, city, or town is allowed to issue debt as well; but this debt is not ‘reserve quality’ and does not serve as a benchmark for national risk and interest rates. A state or local bankruptcy thus does not, by design, threaten the entire financial system. Puerto Rico is currently in the midst of bankruptcy, a fact that in no way seriously threatens the US financial system. To date, the Eurozone does not have an equivalent consolidated central government debt instrument and thus the sovereign debts of each member country end up serving as the defacto reserve quality asset. This spreads the riskier debts of countries like Italy and Greece throughout the financial system. What’s more, since the financial backing for these debts are limited to the finances of individual countries that do not control their own monetary policy (i.e. they cannot print money), the structural risk profile is far higher than traditional sovereign debts.

Given these two critical structural problems, the EU and the Eurozone are home to some of the slowest economic growth in the entire world.

It is with this context that we consider two recent stories that have seismic implications for Europe. The first, from Reuters, reveals that the EU is seriously discussing a unified Eurozone treasury, budget, and finance minister that would hold sway over all participating nations. This would allow for greater synchronization between monetary and fiscal policy.  The second, via Zerohedge, reveals that the EU is planning on pooling each Eurozone country’s sovereign debt into the equivalent of a single Collateralized Debt Obligation (CDO) or Asset Backed Security (ABS) to be named the ‘European Safe Asset’ managed centrally by the EU.

These two developments are tremendously important for two reasons. First, they are the clearest signs to emerge since the very birth of the Euro that the EU grasps the underlying structural problems that have undermined their efforts (problems that we have been discussing for a long time). Second, it signals that EU leadership feels that they are consolidating enough power to federalize the EU.

With regards to the question posed at the start of this article (will the EU move towards federalization, or decentralization), EU leaders are interpreting President Macron’s victory in France as a green light to advance the federalization of Europe. It is much less clear that the actual residents of the EU want to go in the direction of federalization. Will entrenched political parties and the voting public in Germany, Greece, or Italy, really be willing to surrender control over their own tax rates and spending priorities to unelected officials at the EU? It would be a serious mistake to assume that just because President Macron defeated Marine Le Pen in France, the tide of anti-EU sentiment has passed. There is an ocean of difference between giving people a binary choice on the issue of whether they wish to remain in the EU (Brexit would be an example of this) versus a presidential election where an individual political candidate’s personality and policies on a range of non-EU issues come into play. Support for leaving the EU is assuredly far higher in France than Marine Le Pen’s 33.9% result in the recent election. Without a doubt it is yet higher in Italy and Greece. While it may seem like an opportune time for EU leaders to consolidate power, it is unlikely that the majority of Europeans want to go in this direction.

Finally, with regards to whether or not the EU’s plans to consolidate their debt will even work, we note this reaction from Martin Armstrong, perhaps the loudest and most consistent voice on these issues:

“This is intended to pack the national government bonds into securities in order to ensure the financing of the states even after the end of the ECB’s buying-up program. Draghi has created a huge problem buying 40% of the government bonds. Who will buy when the ECB stops?

This is the crash and burn. The EU officials hope and pray that this scheme will increase the demand for governments’ debts of the weaker economies within the Eurozone. They also hope that this will secure the reserves of the European banks where right now a good stiff wind will blow them over. This, they hope and pray, will better diversify bank risks by diversifying their portfolios and ignoring political problems emerging in the south.

This is still a half-hearted measure to move toward federalization of Europe without consolidating the debts, which they fear will still be rejected by the North v the South…

Under this scheme, the idea of creating an ABS instead of consolidating the debt runs the risk that countries like Germany will find themselves (1) no longer the target for a capital flight among Eurozone states, and (2) that the overall interest rate will rise because of the lower quality being included. Therefore, you will not achieve the lowest rate for all as initially proposed back in the ’90s, but rates will rise to reflect the risks in Southern Europe.”

One final point to make is that the exact same approach was taken with risky mortgages in the US in the run up to the 2008 financial crisis. Low quality, risky mortgages were packaged with higher quality ones in CDOs for many similar reasons, yet in the end they were one of the worst performing assets in the financial crisis. Bad debt is a bad debt. Whether you pool it with other debts doesn’t change the fact that someone can’t pay up.