The Eurozone dumbbell trap

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The Eurozone is stuck in a dumbbell trap where economies are socially, economically & politically diverging - clustering on either side of a dumbbell. The longer this divergence continues, the more likely that the European construction, the bar that holds them together may collapse under the weight of contrasting and conflicting needs & perspectives.

The spreads between Spanish and Italian bonds and German bunds are once again on their way up. Even as the borrowing costs for Spain and Italy come dangerously close to Euro area records, the German government is able to fund itself at all-time record low interest rates with significantly negative yields. The two are of course connected as uncertainties about the economic situation in Spain and Italy drives investors into German bunds. The more this happens, the more the already high degree of asymmetry between the economic situation in Germany and the troubled economies gets reinforced as the average borrowing costs of the Spanish & Italian sovereigns creep up and those of the German government fall.

Not only that, but the more the economic situation between Germany and the rest diverges, the more legal bank deposits and savings and illicit undeclared wealth flow from Italy & Spain to Germany and other parts of the EU that are doing rather better. Italians have supposedly replaced Russians as the big guns in top end London real estate deals. This depresses tax revenues in Spain and drains demand from the economy as well as weakens the already fragile banking system. The German banks meanwhile are flush with cash and lending both for real estate and other purposes is cheap and easy to come by. The diverging credit conditions further fuel the economic asymmetry between the two countries.

Spanish, Italian, Greek and Portuguese professionals are also moving to Germany and the demand for courses in German is on the rise. Structural reforms that will make it easier to set up businesses in troubled economies are all well and good but these work best when entrepreneurial talent is at hand to make use of these opportunities. Faced with shrinking economies, difficult credit conditions and record low levels of employment, the best talent is migrating, often to Germany. The influx of this talent will further add to German growth and leave the crisis economies poorer in talent and growth potential.

Politically too, the economies are diverging sharply, particularly in what they think of the European Union and its institutions and each other. While the German-Greek spat and divide where elements in both societies are beginning to really dislike each other is an extreme version, a similar divide is emerging for other countries too. More than this bilateral schism what really matters is what citizens in each other countries think about the European Union and its various institutions. Slowly but surely, we are seeing the emergence of an anti-EU opinion in both the north & south. Eventually they could both end up hating the European Union, but for entirely irreconcilable reasons.

As things stand now, market panic about Italy & Spain, drives investors, wealth and talent towards Germany reinforcing the already massive divide between Spain, which is facing record high levels of unemployment and Germany which faces record low unemployment. For now, the crisis feels abstract in Germany  & the flight to safety simply reinforces the perspective that many Germans hold that they are doing something right and if markets are panicking about Italy it can be resolved if only the Italians did more of what the Germans do.

This means that Germany has the ability to help the crisis countries in the Eurozone, but the dumbbell effect reduces its willingness to do so. Inevitably, Germany cannot stay immune as more of its neighbours get caught up in the crisis and its economy starts to bleed. But even as that happens the dumbbell effect may remain in play as Germany is likely to become the one eyed in the land of the blind and its relative safety that is a driving force for the effect.

What Spain & Italy need in order to restore competitiveness is low rates of inflation and for this to happen Germany, which is genetically allergic to any talk of inflation must be willing to tolerate higher rates. That it remains reluctant to do so is an understatement. Even if it did, the very same low rates of inflation that would help increase competitiveness in the crisis countries will make the real burden of debt in these countries worse.

Many feel that it’s only after the crisis becomes real for it that Germany’s willingness to do more would increase. The problem is that it’s ability to do more and help rescue the Eurozone would have already diminished by then. The longer the EU strategy remains the same, the more the danger that the bar that holds the two ends of the dumbbell together may give way. That must not be allowed to happen. The ECB remains the only institution strong enough to bring the two ends of the dumbell together, at least in the short term.

Sony Kapoor 

Managing Director