Is Europe past the worst or is it edging closer to the cliff? Vehement arguments are made on both sides with each trumpeting data points which confirm their view of Europe’s future. The optimists latch onto any number which comes out better than expected (eg. German industrial output) while the pessimists do the opposite (eg. French industrial production). However in the din of daily data and news releases, the difficult task of constructing a larger picture from these jigsaw pieces is often left unfinished. Moreover, the task itself has been made seemingly unnecessary by the magnanimity of central banks. After all, only a fool would sit and solve jigsaws when the bar is open.
Crack central bank corps with papier-mâché bazookas have kept vigilantes at bay and convinced the market to advance without thought to what lies on the other side of the hill. To policymakers victory must seem inevitable as Italian 10-year yields have smashed through 4%, Spanish are about to follow and even Portugal has regained access to bond markets. However looking beyond the liquidity-fueled surge, internal stresses within the Eurozone are growing stronger.
These stresses which are forcing the Eurozone towards breakup can be classified into financial, economic and political. These exist in every country and intensify during recessions. They are due to the divergent outcomes for people, groups and regions in a capitalist system. It is not the size of the pie but how it is shared which results in conflict. For example, within the UK there is financial stress due to the difference in the ability of SMEs and large companies to borrow. There are also economic stresses between the more prosperous south and the less prosperous north which are captured by unemployment and growth numbers. These lead to political stresses which are reflected in support for differing policy prescriptions. In addition, some political stresses are rooted in cultural differences such as the demand for Scottish independence.
Purely the existence of stress does not imply that a country is destined for breakup since cultural and social commonalities exert a much stronger binding force. Analogous to an atom, these commonalities are the strong force keeping the atom intact over the electrostatic forces of repulsion. However, the Eurozone is not a country and there are few cultural similarities between its members, eg. Greece and Germany. It is akin to an artificially constructed unstable isotope. During the boom, stresses were reduced and the Eurozone not only stayed intact but expanded. With the advent of the financial crisis, the external integrating force has weakened even as stresses have strengthened. Thus the probability of disintegration has risen significantly. History shows that pan-European empires have crumbled with the decline of the dominant integrating power at that time. This time is not much different.
Since numbers captivate more than words, a Schism-o-meter can be designed to measure the internal stress within the Eurozone1. Financial stress can be measured by the divergence in borrowing cost to households, companies and sovereigns. Economic stress can be measured by looking at the divergence in per-capita GDP growth, employment and cost of living (inflation). Unfortunately, political stress is not as amenable to quantitative capture as these two. There is no index of diplomatic bonhomie amongst nations, nor is there any reliable indicator of public sentiment. However since financial and economic stresses usually lead and manifest themselves politically, a Schism-o-meter based on these is still useful.
The graph below shows that stresses, although elevated, have reduced after Draghi’s “whatever it takes” reassurance.
Graph: Schism-o-meter points to reduced stress in Eurozone post Draghi
Source: Data from Eurostat, Author’s calculations
However, before the Nobel Prize is awarded to the ECB, it would be instructive to check what’s going on behind the headline. The improvement is mostly due to the rally in sovereign bonds which easy monetary policy has engineered. The divergence in access to funds for companies and households, except mortgage borrowing, haven’t improved (the broken transmission mechanism worrying ECB). Not surprisingly, employment outcomes are diverging across the Eurozone and so is per capita GDP (albeit slowly). Convergence of inflation outcomes might have been encouraging were low absolute levels of inflation not indicating a risk of deflationary collapse.
Although the Schism-o-meter points to elevated levels of stress, both optimists and pessimists can interpret it as they want since it provides little guidance on the future evolution of stresses. Is it a start of re-convergence or a temporary central bank hopium shot? To complete the picture it is imperative to consider the political dimension. Despite difficulties in measurement, political stresses have increased as shown by the rise of Syriza, Movimento 5-stelle, Alternative für Deutschland, etc. Moreover the sniping between North and South has increased with cracks appearing even in the much vaunted Franco-German partnership. Ultimately, as happens so often in life, one has to move beyond data and reach a subjective assessment. For the Eurozone one gets a sense that Draghi et al. are singing ‘Solidarity Forever’ even as the stage starts to sway.
1. Schism-o-meter is an average of the linear combination of coefficients of variation (rebased to 100 on Jan-2003) for (1) Annual percentage rate of charge on consumer loans to households (2) Annual percentage rate of charge on housing loans to households (3) Annualised agreed percentage rate on total new business loans to non-financial corporations (4) EMU convergence criteria bond yields (5) Seasonally adjusted quarterly GDP per capita (6) Unemployment rate (7) All items HICP 12 month moving average. (1) – (4) are weighted by national GDP while (6) & (7) are weighted by population. This ensures that divergence between bigger/more populous countries is given more importance.