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Yesterday, the German constitutional court made its decision. And the eurozone breathed a sigh of relief.
The bottom line is that the European Stability Mechanism (ESM – or the big bail-out fund, as we call it) does not go against Germany’s 'basic law'. This means the ESM can finally go ahead. Any further increase in its value will have to be agreed by the German parliament, but this is as much a face-saving measure as anything else.
On the face of it, this seems a victory for the euro. It suggests that Germans at all levels will do anything to try to save it. Indeed, the court mentioned that it took into account fears that any delay would entail “massive consequences for some member states”.
It also suggests that however tough politicians talk, neither the ‘peripheral’ nations nor the countries of northern Europe have the courage to pull the plug on each other.
All of this may be true. And certainly, the chances of full-blown eurozone quantitative easing (QE) are now much higher.
However, that doesn’t explain the rally in the value of the euro. While this might be down to relief that the currency has been saved from break-up, QE certainly won’t be good for its value in the long run.
So while we still like Italian, Spanish (and for the bold, even Greek) shares, we think the currency could be in for a fall.
Money printing will weaken the euro
There are two main reasons for the European Central Bank (ECB) to engage in QE.
The first is to ease the fiscal crisis in various nations by using the central bank’s ability to print money (electronically) to buy debt. Bond buying by the ECB will push down the yields on bonds, and therefore the cost of government borrowing. We’ve seen this happen in the US and the UK.
The second reason to do QE is a little more controversial: it’s to stimulate demand in the economy by putting money in the pockets of firms and households via banks and pension funds.
We can’t be sure that QE actually does this very well. Britain’s economy, for one, doesn’t seem to have benefited much from this aspect of QE. However, there’s one thing we can say – and that’s that QE hits the value of the currency. That makes sense – if you print more money, then all else being equal, the value of that money is going to fall.
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The euro could still break up
Capital Economics also thinks that the risks of a euro breakup haven’t gone away. It thinks that the ESM and ECB have roughly €800bn in funds to buy bonds. While this certainly looks impressive, it would only cover Spain and Italy’s financing needs for the next two years. It also leaves nothing for any of the other highly indebted countries.
They also point out that agreeing an aid package, the precondition for any more QE, will take time. Already, Madrid is refusing to make any more concessions on budget cuts. Indeed, the Spanish PM has pledged that he will not cut state pensions further, a key demand.
While this could be a bluff, it shows that it may take longer for the ECB to start buying bonds than many people think. The longer the gap, the higher bond yields could start to rise.
And while Angela Merkel’s government has won a legal victory, it still has to fight a political battle. Indeed, the case has led to a surge in German anti-euro sentiment. Polls now suggest that a majority of Germans want to bring back their old currency.
The large number of experts and academics who backed the challenge also show that opposition to bailouts is spreading to policymakers. Even though a euro exit would make German exports dearer, some business leaders have called for a return to the deutschemark.
The matter may come to a head sooner than later. One theory doing the rounds is that the talk of bond buying is only designed to buy time. The FT claims that the US has asked Brussels to delay any tough action until after the US elections, to prevent it affecting the outcome. While this is only a rumour, the International Monetary Fund’s report on Greek progress will now come out in November, rather than this month.
Whatever the ECB and Germany decide, the euro is likely to fall. Money printing on the scale necessary to kick start growth and bring debt down will be inflationary.
On the other hand, while a breakup of the euro will cure many of the imbalances, it will also make assets such as gold attractive (partly because any countries leaving the euro would likely end up printing their new currencies anyway). Either way, gold still looks like a useful insurance to be holding in your portfolio.
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Matthew Partridge
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