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Ahead of the curve: Europe in a moral trap

May 5, 2020

A commentary by Jürgen Lukasser, Chief Investment Officer of LGT Bank Austria, on interest rate developments in Europe and necessary reform steps in Italy

Ahead of the curve: Europe in a moral trap

This time we simply have to agree with the former Greek finance minister and left-wing economist Yanis Varoufakis. In his guest commentary in the daily "Der Standard" of 24 April 2020 he describes why solidarity is not what Europe needs at the moment. The starting point of the debate was the fierce opposition of Dutch Finance Minister Wopke Hoekstra to the idea of a common European debt. As a result he was considered a heartless northerner both west of the Rhine and south of the Alps. The current pandemic is certainly a circumstance that must be described as a force majeure. Another fact, however, is that in the past decade countries such as Italy and France have made no attempt whatsoever to take the necessary steps towards reform and instead have cheerfully continued to build up debt.

The ongoing discussion on a communitarisation of European debt thus gets to its true core. This is a well-known economic dilemma: "moral hazard" or the so-called free-rider syndrome. In this context, the question arises whether it is justifiable for states that have done their job properly to assume liability for those countries that obviously do not prioritise these tasks sufficiently. The answer to this question goes straight to the root of the weakness of monetary union. When monetary union was founded, fiscal union was dispensed with out of consideration for national interests. Instead, criteria of the Maastricht Treaty, which were considered binding at the time of its creation, were defined.

Unfortunately, the history of the Euro Zone shows that budgetary discipline is not a particular strength of many Member States. The corona pandemic was, of course, unforeseeable, but it is clear that, in this state of affairs, national budgets cannot cope with the stress of an external shock.

The geographical and emotional division of Europe has never been more obvious than it is today. The reasons for this are to be found in deeply rooted cultural differences between Germany and France as the most important economic nations in the monetary union. While France sees itself as a central state, the federal principle is sacred to Germany. A fiscal union for Europe seems difficult to reconcile with the idea of a federal principle. Another major cultural difference - and this brings us closer to the core of the "moral hazard problem" - is the way in which crises are dealt with: in France, the approach of "crisis management" is met with sympathy, in the context of which one can sometimes disregard established rules, as opposed to a strictly rule-based approach, which is a popular choice in Germany and nowhere is the difference more apparent than in the development of public debt in the last decade. The crisis management approach leads to a steady increase in government debt due to weak growth. With low interest rates, this is also politically easier than implementing reforms. In Germany, by contrast, the Maastricht rules were successfully resumed after the financial crisis. This cultural difference is at the heart of the moral hazard problem and therefore provides no basis for the communitarisation of debt. Even if national governments decide to communitise debt, these differences mean that opposition is bound to encounter headwinds. 

But one thing is clear. Italy will not manage it alone, especially if interest rates eventually start to rise. Currently the market is trading 10-year Italian government bonds at a yield of around 1.7%, i.e. with a spread of around 210 basis points. The market is therefore pricing in that ESM and ECB are doing everything possible to ensure the existence of the euro. At the same time, this removes any disciplinary effect of market forces, as interest rates remain unnaturally low. The ECB can thus give Italy a window of opportunity to implement reforms. Of course, the Central Bank cannot implement reforms. 

Italian government bonds are reminiscent of Schrödinger's cat[1], because they are alive and dead at the same time. The box will be opened when the market tests the willingness of the ESM and the ECB to intervene in the markets or the belief of investors in the ability to repay debt. The assessment that this test is coming is realistic.

Italy will not be able to avoid unpleasant reforms in the long run. More European integration in the direction of a fiscal union is the only sustainable way to protect the single currency. Populists will talk about the founding of the "EUSSR". The alternative is to start again asking questions about the function and existence of the common currency. Hopefully Christine Lagard will then find the right words, just like her predecessor Mario Draghi.

 

What does this mean for the investor?

Actually, one can only recommend to steer clear of European government bonds. Once you weigh up the risk and return, that is the conclusion you come to. Corporate bonds with good credit quality are now once again a good alternative; the spread in Europe is currently 1.86%. A look at the probability of default for bonds depending on maturity and creditworthiness shows that these are in fact low in the investment grade range (lower limit BBB-) and only rise significantly in the high yield range.

In the longer term, one can only recommend to a Euro investor to ensure a clean risk diversification on the currency side as well, because the described developments could also cause trouble from this side and one should not forget a gold share in the portfolio at the moment anyway

 
[1] This is a thought experiment of the Austrian physicist Erwin Schrödinger. The box contains a cat, a radioactive preparation, a detector for the radiation produced during decay and a lethal amount of poison that is released when the detector responds. Without opening the box you cannot tell whether the cat is alive or dead, so you must assume that the cat is both alive and dead. Only the opening of the box allows to determine the actual condition of the cat.

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