United States of Europe?

IT has long been said that the Euro was just a step towards a federal Europe. When the European currency went into crisis, as it would be assured to do so, it would force closer fiscal integration -effectively meaning closer political union.

Closer union appears to be coming true. The Euro, in its old form, has fallen into crisis and the price European countries have to pay is a large loss of sovereignty.

News of the turbulent European summit had fed itself into the Asian markets. Falling 35 centavos against the USD as Europe’s leaders met, the Peso suffered the impact of investors moving to the dollar as a safe-haven from the crisis whilst the Philippine Stock Exchange index fell by 0.47%. 

The summit concluded with 26 of the 27 member nations agreeing to stronger fiscal union, with the United Kingdom opting to veto. The broad agreement led to the Peso rebounding when the markets reopened after the summit, gaining four centavos. But while the initial rebound is encouraging, the central problem of uncertainty about what will happen in Europe remains. 

The question for Philippine investors is how will Europe resolve the crisis and is a United states of Europe on the way? In searching for an answer to this question it is essential to unpick the complex web of Europe, its politics and the diverse range of opinions in the member nation’s populations. 

Nationalists would consider a federal Europe disastrous. In reality, there are not so many nationalists in Europe these days and many countries, and their populations, consider themselves European and see little problem with further integration. 

What is set to happen is that the European super state will hold the cheque book of euro member countries; or at least be able to snap it shut should any one country wish to run away with its local budget.
Money is power and once ultimate budget power is gone, political power will subsequently be drawn into the federal centre. This illuminates the character of the current crisis; it is purely political. Come what may, economic ramifications of the crisis are secondary to those of the political necessities.

Central banks and their job, of fixing interest rates, is the primary bastion of central state control over free markets. Consequently, it is not surprising that this is where the economic trouble has come to a head.

A decade of low interest rates has allowed states in the developed world to build up titanic debts. Europe, with its socialised model, has bloated to such a degree that the world demands higher interest rates to support its debt levels than most of Europe can afford to pay. 
Due to these countries sharing a single currency they cannot adjust their currency through relation to cope. They cannot “print” and the ECB is bound by charter and German ire from doing so on their behalf. 

They therefore need a hand-out from the better off members of the currency union, in this case Germany. 

Germany will only accede to this if it, or a proxy, has control over the purse strings to make sure the wastrel of Europe won’t spend Germany into ruin as well.

The UK doesn’t like this one bit as it sees many problems. The UK doesn’t like the idea of a United States of Germany and sees that, in a federal Europe, Germany will rule. There is no real reason to loath this idea, except geo-political pettiness, which of course politics abounds in.

The other reason is the UK feels Europe is gunning for the British financial sector, which accounts for 20-25% of the UK economy. 
This is ironic, as UK politicians and media have been pillorying the financial sector for years. However now like an abusive spouse, the British government is frightened of losing its rich wife. That aside, the perception is that Europe wants to strip that financial industry from London and ship it to Frankfurt and Paris; a unified Euro based Europe would present a platform to do just that, leaving Britain a poor toothless semi-autonomous region.

From an investors point of view the questions are many; will this political process solve the economic crisis of Europe and how should one invest accordingly? 

The obvious outcome of this whole mess is stagflation. Most of Europe will be trying to get their economies back into balance through austerity which means lowering the fat share of GDP made up by government spending. This won’t make it easy for the real economy initially, so there will be no recovery in sight for a long time. 

There will undoubtedly be inflation, which will give a lift to economic activity. It still remains to be seen though if Germany will let the EU have any meaningful bout of inflation, to evaporate its mountain of debt.

It is the level of inflation that will set the clock to recovery running - 5-7% means five years of austerity, 2-3% a decade or more. 
Yet the story is not over until the countries of the eurozone sign on the dotted line and perhaps have a round of referendum. Even then, as is the way of politics, a deal is a deal on until the deal is broken. 

Large parts of Europe may simply not be able to stomach the prospect of a decade of stagnation, so a deal may simply not hold for long.
The key indicator is inflation. If that starts to rise then the investor can be sure that the real recovery is on its way. Otherwise Europe will be in for a Japanese style lost economic generation, with a strong Euro and a moribund economy as far out as is guessable.

Ultimately the market will decide on the lead up to the spring agreement. The Sovereign bond yields of Europe will ebb and flow and if the market flatly refuses to fund euro governments, whatever the politicians agree, then the Euro will break up and Europe will go back to the way it was in 1990s. If the markets will lend to Spain, Italy and Portugal at around 5% then a new era of The United States of Europe beckon.

A United States of Europe would redraw the world’s economic map. A Euro-tracked currency like the Peso would, like this last week, face the challenge of coping with the inevitable proceeding political and economic confusion. 

With the IMF cutting the Philippines growth forecast due to falling demand for exports and disappointing growth figures, an end to the ongoing uncertainty in Europe could just be the news that Filipino business has been waiting for -- along with the rest of the world.