investment insights
Poor neighbours: Europe’s mounting north-south divide
Lombard Odier Private Bank
Key takeaways
- The pandemic highlights the EU’s philosophical differences and some lack of solidarity within the eurozone
- The tensions are about whether to share the burden, rather than the financial ability to support
- A German constitutional court ruled that the ECB must justify asset purchases, in a politically awkward decision that challenges the supremacy of the European Court of Justice
- We have increased exposure to US and Asian equities, which should benefit from growth in tech and health care, at the expense of European equities.
The Covid-19 pandemic has tested health systems and shut economies, damaging industries and creating widespread hardships. The European Union’s nation states, unequally impacted by the crisis, have struggled to unite around a common response, highlighting once again the different budgets, and attitudes to debt, of north and south.
For now, keeping the EU’s members together looks more urgent than any discussions about greater federalisation. What started out as a public health crisis is adding a political dimension that the European Commission itself, the EU’s executive arm, describes as a threat to the eurozone.
The health responses to the pandemic, from shutting borders to sourcing medical supplies have been stubbornly national. The early weeks of the crisis exposed this lack of solidarity, as Italy accepted facemasks from China when neighbours banned exports of protective gear. European Commission President Ursula von der Leyen apologised to Italy for failing to come to its aid.
Epidemiologists will study the varied public health impact of the coronavirus for years to come. The immediate pan-European question is one that has shadowed the European Union since its foundation, who should pay? That question is not about liquidity. No-one is asking whether the EU can afford to support its economies, at least in the short run.
The big question is rather whether countries with strong credit ratings such as Germany or the Netherlands, should support countries like Italy or Spain, to protect living standards and consumption? Debt mutualisation, combining tax resources or fiscal firepower are not popular among northern countries who consider themselves more spendthrift than their southern neighbours.
Common cause
It is easy for critics to point to a lack of fiscal and monetary coordination. Unlike the US or China, the 19 eurozone countries have no single mechanism for issuing debt. The European Central Bank only acts for euro members and only has one mandate: price stability. After much resistance from the Netherlands in particular, the eurozone’s finance ministers did agree last month that countries can borrow from the emergency European Stability Mechanism for health spending and from European Investment Bank programmes. That followed a falling out over proposals by Italy, Spain, France and six other countries to issue collective eurozone debt or ‘coronabonds.’
Just as the aftermath of twentieth century conflict prompted France and Germany to find common cause over coal, steel, farming and fish, the bloc has found that the 21st century’s challenges – the great financial crisis, the sovereign debt crisis and now Covid-19 –require massive government intervention to keep economies moving. For decades, the EU’s only common budgets were for agriculture and fisheries. An EU-wide post-pandemic recovery fund, worth EUR1.5 trillion, the equivalent of 10% of the region’s Gross Domestic Product, dwarfs the common budgets for agriculture and fisheries, which total EUR 65 billion each year and have pitted net contributors against net beneficiaries for decades, challenging cultural attitudes to debt.
Just as the European response to the crisis started to look more joined-up, the tensions were exacerbated on 5 May, when Germany’s Karlsruhe-based constitutional court ruled that one of the European Central Bank’s quantitative easing programmes violates the EU’s principles because the measures are disproportionate and have not set out the economic policy effects. The legal challenge, lodged by a group of Eurosceptic plaintiffs, included members of the rightwing Alternative for Germany (AfD) party.
The court challenges the ECB’s Public Sector Purchase Programme or PSPP, which dates from 2015, and buys government bonds to allow national central banks to expand the credit available to their economies. The German central bank has a three-month deadline to justify the spending. Without which, the court suggests that the Bundesbank look at ways of selling the purchased assets. The decision does not specifically challenge the ECB’s Pandemic Emergency Purchase Programme, or PEPP. The ruling does undermine a decision by the European Court of Justice (ECJ) in 2018. Legally, the ECB is answerable to the ECJ.
‘Ridiculous’
Reactions were swift. “The court’s arguments are ridiculous and we could easily answer them in five minutes, but we absolutely should not do so,” one ECB council member told the Financial Times.
German Chancellor Angela Merkel took a positive view, describing the result as “solvable,” according to a Reuters report. The request to the ECB to show that asset purchases are proportionate to any economic and fiscal impact may even strengthen the eurozone’s mechanisms, according to a spokesman for Mrs Merkel’s party.
The German court decision is certainly politically awkward because it may open the door to other national court challenges to ECJ interpretations. And it may require the Bundesbank to draft a justification. But it is also a healthy part of the checks and balances that hold institutions responsible in a democracy.
The bigger issue is whether Europe’s citizens would prefer to stumble forwards, responding to imperfect choices, adjusting direction, or simply bow to an unaccountable central authority as in China, or prefer to go it alone, Brexit style?
Even the German court acknowledges the messy nature of the EU and its membership obligations. EU members remain the ‘Masters of the Treaties’ and “the EU has not evolved into a federal state,” they wrote, and “certain tensions are thus inherent in the design of the European Union.” Law that evolves through test and precedent may be a rather more Anglo-Saxon approach than many EU member states are used to, but it is also pragmatic.
Central banks for individual nation states around the globe have reached for chequebooks to keep economies from collapse. It would be hard to argue that the ECB should not do the same and that its responses to Covid-19, a shock of historic proportions, are unwarranted or, for now, disproportionate.
Comparisons with the apparently unquestioned monetary responses of China are inevitable but should not be overplayed. Where the Chinese response looks streamlined, and closed to questioning, the EU’s measures inevitably look messy. The Karlsruhe court’s decision is part of an awkward but useful system of checks and balances that make for an imperfect but evolving model. After all, the EU seems accustomed to working from one crisis to the next.
In the last few months, we have increased the liquidity in our portfolios and strengthened the cushions, whilst maintaining a slight underweight in equities. This reflects, in part, the risk of low oil prices. Once the worst of the pandemic’s effects are behind us, we expect to see growth in the information technology and health care sectors. These industries dominate US and Asian stock indices, and for this reason, we have increased our exposure to US and Asian equity markets, and reduced our exposure to European equities.
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