There is little doubt that the realities of Brexit have fundamentally altered the world’s perception of Europe as a unified entity. However, it must be noted that the threats to the continual existence of the European Union are the result of institutional weaknesses that predate Brexit. As time progresses, the structural weaknesses of the European Union will become increasingly evident, specifically within the Eurozone.
Since its official launch in 1999, the Euro has become one of the world’s leading currencies and is the official currency of 19 of the EU’s 28 member states. It has served as a key instrument for helping create a common European market and ensuring “an ever closer political union among the peoples of Europe.” And up until the Financial Crisis on 2008, the Eurozone was considered a resounding success, most notably in the areas of fostering price stability, facilitating economic integration, and improving financial certainty.
However, the Financial Crisis and subsequent Eurozone Crisis brought into question the structural soundness of the Eurozone.
To fully understand the Eurozone’s structural problems, let’s look at a brief overview of economic theory regarding optimal currency areas.1 For an optimal currency zone to exist, it must have similar economic structures, cycles, markets, and cultures. These similarities will help enable national economies to more easily adjust to the natural boom and bust cycles of the economy. Otherwise, it is possible for some portions of the currency area to prosper while other areas languish.
Regrettably for the Eurozone, the national economies of its member states are vastly different structurally. For instance, whereas Germany’s trade surplus represents 7.2 percent of its total GPD, Greece has a trade deficit of 0.2 percent. The consequence of these structural dissimilarities is each member of the Eurozone supports different economic priorities. As a result, the Euro does not reside in an optimal currency area.
To maintain solvency (the ability to meet long-term financial obligations), the Eurozone must pursue one of the three possible solutions: price and wage adjustments, capital and labor mobility, or transfer payments. Unfortunately, the European Central Bank (ECB), the entity tasked with managing the Euro’s supply, has a strict policy of guaranteeing price stability, thus negating the possibility of inflation as a tool to promote price adjustments. Another confounding factor is the tendency for wages to be sticky due to the unpopularity of wage cuts. As a result, the first potential resolution is dead on arrival.
The second possible solution is to encourage the movement of capital and labor to help member states’ economies adjust to varying market conditions. Close inspection of the movement of capital in Germany, France, Italy, Greece, and Spain reveals that foreign direct investment originating from other Eurozone nations has amounted to less one percent of each nation’s gross domestic product since the 2008 Financial Crisis with only minor exceptions. As a result, it is safe to assert that capital is fairly stationary within the Eurozone.
Inspection of national unemployment rates in the same five nations suggests labor is also stationary. Germany, the Eurozone’s largest economy, has the best unemployment rate of just under five percent, nearly full employment. Meanwhile, France and Italy, the second and third largest Eurozone economies, have unemployment rates of over ten percent. And disturbingly, Greece and Spain have unemployment rates over of 20 percent. The data also shows that unemployment rates in these five nations have been static for the past several years, thus indicating labor is not moving to regions with better economic opportunities.
In order to remain solvent, the Eurozone must rely on one final solution: transfer payments. Yet, unlike the other two solutions, transfer payments are inherently political as they involve transfers of wealth from prosperous to indebted regions.
It is therefore ironic that just as the Eurozone was initially created as a political project so too is its long-term existence dependent upon politics.
Since the 2008 Financial Crisis, the transfer payment of choice has come in the form of sovereign debt relief, especially for Greece. Starting in 2010, the ECB has structured three separate debt relief programs to ensure the solvency of the Greek government. And although nations such as Germany may grow increasingly impatient with the ongoing Greek drama, it is unlikely that Greece will be allowed to default on its debt in the wake of a Brexit. However, the greatest threat to the future of the Eurozone is not the possibility of Greek bankruptcy, but the potential for an Italian banking crisis.
As the Eurozone’s third largest economy and the EU’s fourth largest economy, a systematic failure of Italy’s banking system would have grave implications. Review of foreign direct investment within the Eurozone reveals instances of substantial capital flight from Italy in 2008, 2010, and 2012. This is a major red flag concerning the health of Italy’s financial sector. Indeed, the risk of a possible financial meltdown cannot be overstated. At the height of the 2008 Financial Crisis, five percent of loans in the U.S. were classified as non-performing.2 It is presently estimated that up to seventeen percent of all Italian bank loans are non-performing.2
If Italy’s banks were to experience a financial collapse, the geopolitical ramifications would be staggering. First, it could trigger a second global recession. But the second consequence is of greater long-term significance due to the irony of the European Union’s institutional structures, especially in the Eurozone. While fostering economic interdependence may increase gains obtained through trade and assist in forging Europe into a single, unified entity, these same structures ensure that economic and financial crises are not isolated events.
While the Eurozone, led by Germany, was able to prevent a financial meltdown in Greece, will it be able to prevent the same from taking place in Italy? It is not likely.
Italian financial institutions are deeply intertwined with their German and French counterparts, thus making it almost certain that a financial crisis in Italy would spread to the rest of the Eurozone.3 This problem is compounded by the fact that Deutsche Bank, Germany’s most important financial institution, experienced a loss of 6.7 billion Euros last year, failed its U.S. stress tests for the second straight year,4 and was labeled by the International Monetary fund as “the most important net contributor to systemic risks.”
Additionally, the value of Germany’s exports is equal to 46.1 percent of its GDP, 58.13 percent of which go to EU countries. Consequently, if fears of a financial crisis in the Eurozone were to dampen consumer demand in the greater EU, Germany’s ability to export goods would be injured and constrain its ability to stave off financial disaster in rest of the Eurozone.
Due to the inability of Germany and other Eurozone nations to contain and mitigate an Italian financial crisis, it is not impossible to foresee some nations desiring to regain control of their political and economic future by following the lead of the United Kingdom and exiting the EU. Already in the aftermath of Brexit nations such as the Netherlands, a founding member of the European project, are discussing a withdrawal from the EU. Clearly, in the face of such rapidly changing economic and political conditions, the future of the European Union is truly unknown.
- Sheridan, Jerome. “The Consequences of the Euro.” Challenge 42, no. 1 (1999): 43-54. http://www.jstor.org/stable/40721919.
- Legorano, Giovanni. “Bad Debt Piled in Italian Banks Looms as Next Crisis.” WSJ. July 4, 2016. Accessed August 15, 2016. http://www.wsj.com/articles/bad-debt-piled-in-italian-banks-looms-as-next-crisis-1467671900.
- “American Exposure to the European Financial Crisis.” Geopolitical Futures. July 14, 2016. Accessed August 15, 2016. https://geopoliticalfutures.com/american-exposure-to-the-european-financial-crisis/.
- Tracy, Ryan. “Fed Stress Tests Clear 31 of 33 Big U.S. Banks to Boost Returns to Investors.” WSJ. June 29, 2016. Accessed August 15, 2016. http://www.wsj.com/articles/fed-stress-tests-clear-31-of-33-big-u-s-banks-for-capital-returns-1467232237.
Guest Writer: Nathan Carson is passionate about identifying geopolitical trends that will impact international stability and food security. He is a second-year Masters student studying Agricultural Economics at Purdue University with a specialization in Agricultural Finance. As an undergrad at the University of Florida, he served as a Scholar for the Challenge 2050 Project and presented research on the use of microloans to help address poverty, food insecurity, and water scarcity in India. Nathan also represented the United States as a delegate to the 2013 Youth Ag Summit in Calgary, Canada where he led a team of fifteen
delegates to construct, organize, and propose a global marketing plan to combat hunger worldwide.