Why the eurozone is destined to flounder

Dawn Kendall, multi-manager at Architas, uses historical examples to pinpoint why the European monetary union is bound to fail in its present form.

President Obama gave his annual assessment of the US last month and so we felt it an opportune time to also review the state of the union a little closer to home and to make our own assessment of the gathering storm clouds surrounding Europe.

The IMF report warning over the outlook for the world economy, with specific reference to Europe, could not have been more inopportunely timed.

This is particularly so in light of the eurozone downgrade in January, the tarnished reputation of the European Financial Stability Facility (EFSF), which also took a downgrade, and the continued failure to find a resolution to the Greek debt crisis.

Although economically sound in its prediction of the risks, the focus on Europe as the reason for global slowdown is somewhat misleading. The European crisis may be a catalyst but it is not the root cause. A structural theme of the global economy in recent years has been continued deleveraging, and this will remain the case for the coming year.

European slowdown

It is true, however, that eurozone economic activity has slowed; the Bundesbank said the European economy contracted in Q4 2011 and it expects it to be flat in Q1 2012.

In Spain, the central bank has suggested the economy will contract by 1.5% as deleveraging of the economy begins to take hold. In light of this, the ECB will come under increased pressure to act. The market is now expecting the ECB to loosen policy further and to continue a debt buy-out programme under the securities markets programme.

In the latter part of 2011, the ECB stood behind the commercial banks and offered unlimited liquidity during the crucial year end period when the market has habitually become less liquid, even during the good times. 

Alas, transfer of debt from the private sector to sovereign balance sheets will not make the debt go away. Although an unattractive prospect and politically difficult to position, inflation will ameliorate the debt mountain facing western economies. And so it is a question of when, not if, inflation begins to return as a significant risk factor.

For the time being, the focus of the ECB must be on maintaining stability through the delicate period of negotiation on Greek refinancing that must reach a conclusion by 20 March when €14.5bn of debt matures and will require funding.