2011 has been a turbulent year for the single currency and you could say it started quite well with the admission of Estonia on the 1st January to bring the number of euro members to 17.
There was optimism among EU ministers that Ireland would be the last European country to ask for a bailout; however the reality was that they were deluding themselves with Portugal already under pressure in the bond markets.
In an effort to restore confidence finance ministers set up what is known as the European Stability Mechanism, worth about €500bn, however it would not come into force until 2013.
By the time April had come round Portugal had succumbed to the inevitable and asked the EU and IMF for a bailout, which was approved in May with a loan of €78bn.
It soon became apparent that Greece, the first European nation to ask for a bailout, was finding that the austerity measures, imposed as a condition of their bailout, were having a toxic effect on their economy, as unemployment rose rapidly and growth slid sharply.
As a result the “troika” of the IMF, ECB and EU insisted that Greece must impose further austerity measures before it gets the next tranche of its IMF loan, raising fears that the country will be forced to leave the Eurozone.
As a result, in July the Greek parliament voted in favour of a fresh round of drastic austerity measures amidst a background of civil disorder and unrest from protestors in the main square at having to bear fresh pain.
In any event the bailout was agreed and the July 21st summit approved a new bailout of €110bn for Greece in addition to the original bailout plan. €37bn of the bailout was to come from (PSI) private sector involvement while there was agreement to boost the EFSF to the full €440bn, however this would require separate parliamentary votes from the 17 members of the euro before becoming valid.
It soon became apparent that there were divisions with Finland breaking ranks and asking for collateral before agreeing to the increase in funds.
With the advent of (PSI) or voluntary haircuts the crisis which, until then had been confined to the periphery, started to spread to the bigger economies of Spain and Italy and the crisis moved onto a whole new dangerous phase.
Yields on Spanish and Italian bonds started to rise as investors began to trim down their holdings of European government bonds and move them into safer German, Dutch and even UK government bonds.
As a result pressure was brought to bear on Italy and Spain to try and assuage the markets that their finances were under control and Italy finally passed a €50bn austerity budget in August after weeks of haggling in parliament in the face of fierce public and political opposition, with the result that several measures were watered down.
With growth in the whole of the Eurozone starting to splutter and stall the realisation started to dawn that without growth the crisis in Europe was starting to spin out of control and the ECB started to buy Spanish and Italian bonds in a an effort to stem the crisis.
Anxiety started to build across the globe with US Treasury secretary Tim Geithner urging European leaders to get to grips with the crisis.
With the IMF, OECD and the EU starting to downgrade growth forecasts for Europe while ratings agencies cut debt ratings on European banks and sovereigns, markets started to come to the conclusion that EU leaders were running out of ideas as to how to deal with the crisis.
Matters came to a head in both Greece and Italy with the replacement of both elected Prime Ministers after much budget backtracking with unelected technocrats, Lucas Papademos in Greece and Mario Monti in Italy.
Both leaders tightened the screw even further under pressure from German leader Angela Merkel who insisted that their economies needed structural reform against a backdrop of civil unrest and rioting.
Summit after summit came and went during October and November each with the dramatic headline “6 weeks to save the euro” or “5 days to save the euro”.
During this time from April until December the ECB raised interest rates twice, exacerbating the crisis in the periphery, before being forced to cut them back in November and December as well as flooding the markets with liquidity to prevent a credit crunch in the banking sector
These headlines culminated in the EU summit on the 9th December which resulted in the controversial fiscal compact from Angela Merkel and Nicolas Sarkozy, ultimately vetoed by the UK.
In any event the rest of the EU members have decided to try and make the best of a bad job by agreeing to an intergovernmental treaty change outside the EU treaty.
The compact proposed the following changes including an agreement to stick to the budgetary disciplines of the original Maastricht treaty which stipulated that deficits should not exceed 3% of GDP and that debt to GDP ratios should not exceed 60% of GDP, with penalties for non-compliance.
These penalties would be decided by qualified majority voting and exceptional circumstances should be taken into account in deciding whether to levy them.
There should also be convergence and harmonisation of the corporate tax base and the creation of a financial transaction tax.
The acceleration of the ESM would be brought forward to 2012 and would work on the basis of qualified majority voting, with no PSI, which amounts to full moral hazard and full exposure to the taxpayer.
The approval of official spending budgets in Brussels before going to their respective member parliaments will also have to be enacted.
This leaves a number of open questions given that the full scale ECB intervention in the bond markets remains “off the table” and Merkel has ruled out Eurobonds or “debt pooling”.
Firstly most EU members are already in breach of the Maastricht criteria which means that in order to get in line with them spending cuts and tax rises will have to be implemented which will impinge growth even further at a time when growth is already stalling. This focus on austerity to the exclusion of growth at a time when Europe is contracting is baffling to say the least, and will ensure a lost decade for Europe if leaders don’t change tack.
The tax harmonisation measures are likely to run into fierce opposition not least from Ireland which has a 12.5% tax rate and is currently the only European economy that is showing positive GDP growth. Any changes here are likely to mean a referendum in Ireland and with EU policymakers reluctant to countenance a relaxation in Irish bailout terms I wouldn’t count on a positive outcome here.
Finland is also opposed to the qualified majority voting on the ESM which starts with €500bn in capital, but the fund when it comes into effect could have the right to increase that to any amount it wants in the future, under article 8.
Governments also commit to providing whatever money it asks for within seven days (article 9) and is probably why Finland is opposed to this on the basis that it could be a blank cheque.
The biggest concern from a democratic point of view is that its board and staff are supposedly free from any national laws and immune from any prosecution for any offence they may commit in the course of their duties.
As we head into 2012 polarisation within the euro area has already started with the UK isolated due to PM Cameron exercising the veto. Much has been written about the wisdom of his actions with a lot of his critics suggesting that he has thrown the baby out with the bath water, however given the obstinacy of Merkel and Sarkozy in driving the new fiscal compact with forensic scrutiny of national budgets one can’t help think that the euro is heading full tilt towards the buffers.
The UK may find it is not as isolated as it once was especially if the austerity espoused by Merkel drives taxpayers to revolt and governments to fall, as has already been the case in over four European countries this year.
The European banking system is fundamentally insolvent, as are some governments, and with cracks already starting to appear it can only be a matter of time before the fault lines start to turn into chasms in the face of zero growth.
Poland has already voiced concerns about the erosion of sovereignty contained in further integration and this could well be the first of a lot more uncertainty and resistance amongst member countries about what is being proposed going forward.
With that in mind it appears highly unlikely that the euro will recover the highs seen earlier this year and could well be susceptible to further downside pressure, given the options facing it.
The bottom line is that for the euro to survive it needs to go for full blown fiscal union, or break up, it’s as binary as that, and currently the odds are on it breaking up, given the obstacles in its way, on a political level, as well as a legal level.
The euro has been slipping back for some time now but it continues to remain fairly robust given the negativity surrounding its future, however this could well change sharply if markets lose confidence in the belief that the ECB will finally do what is necessary to support it, by unlimited intervention in the bond markets.
Draghi seemed fairly unequivocal about the unlikelihood of that happening last week, which suggests that markets think he will blink. The only other option is that markets are being hopelessly naïve.
The key level is at 1.3050 which is the 61.8% retracement level of the 1.1880/1.4940 up move. A sustained break here would target this year’s low at 1.2870 on the way towards 1.2500.