This article identifies the headwinds faced by the EU in the wake of Brexit.
Without the UK, not only does the EU lose much of its importance on the world stage, but the Commission’s budget is left with an enormous hole. That is the decline. The fall is well under way, with capital flight significantly worse than generally realised, as a proper understanding of TARGET2 imbalances shows. Not only is the ECB running out of options, but without major support from Germany, France and Italy, Brussels itself faces a financial crisis. In a highly unusual move, Jamie Dimon of JP Morgan in a letter to his shareholders this week backtracked on his earlier pre-Brexit threat to move jobs from London, declaring that the problem is Europe itself.
Decline
The abandonment of the EU by Britain looks like a stroke of luck – for Britain, if she can extricate herself in time. It exposes the EU for what it is: a failing post-war project. An agglomeration of disparate nations, cobbled together, planned by America in the post-war years, now finds the new American President no longer supports it. The parent is abandoning its child, and so is Britain, American’s closest strategic partner.
This is important. Back in 1947, John Foster Dulles, a US delegate to the UN General Assembly, recommended to Congress that the Marshall Plan be used as “a positive instrument for a united Western Europe”. The following year, in the Economic Cooperation Act of 1948, it was stated “It is further declared to be the policy of the people of the United States to encourage the unification of Europe”.i
European unification was pursued subsequently by the founders of the CIA through the American Committee on United Europe. From the start, America wished to ensure that the European nations would never go to war again, and for a united Europe to form a buffer against Soviet communism. This policy was embodied in NATO, formed in 1949, which according to its first Secretary General, “was to keep the Russians out, the Americans in and Germany down”.
President Trump threatens to change America’s long-standing policy towards Europe. He was almost certainly unaware of the sensitivity of this early history, and the strategic importance of America’s relationship with the EU, when he praised Britain for its Brexit decision. He spoke of the EU in derogatory terms. Doubtless, he has now been briefed by his permanent intelligence staff of the importance of supporting both European solidarity and NATO, given Langley’s belligerent view of Russia. However, the damage has been done. Trump’s apparent refusal to shake hands with Angela Merkel in public on her recent visit, and his demands that Germany pay its share of NATO’s costs, were bad omens.
This might change, if wiser council prevails. But Trump’s vow to agree a new trade deal with Britain, as soon as she can sign an agreement, will have weakened the EU’s negotiating position over Brexit. In approximate terms, a trade agreement between the US and UK involves a total GDP between the two nations of over $21 trillion. The EU’s GDP ex-UK drops from $16.3 trillion to $13.5 trillion, a figure likely to be overtaken by China any moment. And while Britain may quickly achieve a trade agreement with the US, the EU has proved itself incapable of doing so after protracted and fruitless negotiations.
The EU itself evolved from a free trade arrangement between European powers, keeping the rest of the world at bay. Since then, the Soviet Union has fallen and Eastern Europe has been freed from communist oppression. The Iron Curtain has been swept away and new European states have materialised. Emerging nations in Asia, unhampered by wealth-destroying government taxes, have discovered the joy of free markets and are accumulating substantial wealth without western social-democratic baggage.
China will soon eclipse the EU, with a middle class significantly larger. China and Russia between them have already wrested control of commerce over the vast bulk of the Eurasian continent. Russia has an interest in seeing the disintegration of the EU, so she can trade more freely with the individual nation members. This is her practical response to America’s European policy, and will allow her in time to feel her own western borders have become more secure.
The EU is also likely to be side-lined in security matters. The US and UK work closely together on intelligence, with GCHQ by far the most important listening post in Europe. While cooperation on terrorism between Britain and the EU member states is unlikely to be compromised by Brexit, there is little doubt that in NATO-related intelligence generally, the Americans will work increasingly with the UK, and less so with Germany, France, Italy and the rest.
Leaked UK cabinet minutes, reported in last Sunday’s Telegraph, confirm the importance of the security angle, with British negotiators seeing this as a powerful negotiating lever. The Baltic states and the central European nations joined the EU as protection from Russia, attracted by the EU’s reliance on NATO for defence, together with America’s long-standing commitment to keep Russia at bay. Trump’s comments about the EU’s status quo and Britain’s Brexit places these newer EU members in a difficult position.
In future, NATO, upon which the EU relies for defence, will be controlled by non-EU members. The newer EU members will be thoroughly dismayed, and will surely re-assess their strategic options. They will be watching the turf war between Washington and Langley closely, as well as the developing political alliance between Russia and Turkey. They will not want to compromise their relationship with the UK, post-Brexit.
They will also note that American sanctions limit their trade options with Russia, putting them in the front line of a renewed cold war. Trade between Russia and China is booming, and they are forbidden to participate. How would you feel if the alliance you joined is suddenly in decline, telling you what you can and cannot do, threatening to fragment, and is losing control of its defence?
Brussels is now the obstacle for those that believe they are in the firing line. When Theresa May emphasised her hopes that the UK and the EU would continue to cooperate on security, this was diplomatic code for “the EU has a very big problem in this respect”. You can visualise the exaggerated wink that went with it.
Perhaps these realities were aired in the meeting of the remaining 27 states in Malta last weekend, when the Commission presented its draft negotiating guidelines. At that point, the bluster came to an end, and the reality of the EU’s position must have become obvious to all the delegates. The Commission’s President, Donald Tusk, gave a press conference after that meeting, responding to the Brexit letter. His mood was certainly downbeat and conciliatory in tone, a far cry from his colleagues’ bravado of recent months.
How geopolitics will pan out is anyone’s guess. For the moment, it appears that President Trump is moving away from détente with Russia, but that is all part of the turf war between the White House and the Deep State. President Putin is likely to respond with patience, as he has always done, until America settles on its foreign policy approach. Meanwhile, Russia will try to mend her fences with Eastern European nations through trade and diplomacy, hoping to undermine the EU’s solidarity.
Patience will be required because trust levels in Eastern Europe with Russia are close to zero. But as the EU declines, and members threaten to drift away, Russia’s best interest is to do everything to promote constructive, peaceful trade.
That’s probably what galls Langley most: Russia and China are becoming powerful enough to overturn American hegemony in Europe, not through military prowess, but through economic power. China, with Russia in tow, is destabilising America’s post-war regime, and America is losing her grip on global dominance. Her post-war European project has lost its relevance. The European Union will begin to decline both in political importance and in nominal GDP terms when Britain leaves. Compared with the resurgence of the Sino-Russian axis, it will continue to decline in relative terms as well.
…….and fall
Britain leaving the EU will expose a hole in the EU Commission’s budget of about €8bn, out of a total annual spend of €145bn. Of that total, roughly €136bn is committed to redistributions between member states. The EU Commission itself spends the balance, about €8.5bn, on its own administration and projects, so Brexit will cost the Commission its entire net budget.
There is a further problem. Brussels has spending commitments over and above the official budget, which at the end of 2016 stood at a massive €238bn These are commitments incurred but not yet paid for, reste à liquider in the jargon. It includes capital projects and various items such as future pension liabilities for Commission staff. This extra expenditure forms the basis for claims that the UK will have to pay an estimated €60billion as part of the Brexit settlement. Legal advice to a House of Lords sub-committee is that the UK has no liability for this amount, and given it was contracted without Britain’s explicit agreement, its status is certainly questionable. It also ignores the value of Britain’s property rights, accumulated during her membership.
If Britain successfully argues that it has no liability, or at least a significantly lesser one, a funding crisis for the Commission seems certain to ensue. But the imperative in Brussels is to continually expand in order not to lose its reforming momentum, so cutting back has never been on anyone’s agenda, and no one knows where to start. And blind men don’t thank you for giving them a looking-glass.
That’s two years away, but one wonders how these shortfalls will be met. Brussels will doubtless expect to have the annual British contribution underwritten in full by other budget contributors, principally Germany, France and Italy. The funding of the EU seems certain to become a major issue in the coming months in these countries, and it would be a miracle if it is glossed over entirely in this year’s French and German elections.
The euro, TARGET2 and the ECB
Another EU institution in a fragile condition is the euro itself. Last Monday, the Financial Times reported on a survey of reserve managers at 80 central banks, more than two-thirds of which were changing their reserve allocation from euros in favour of sterling. Their greatest fear for 2017 is reported to be the stability of the monetary union, and some of them have eliminated their exposure to the euro entirely, others to only a bare minimum. So, if in line with foreign central banks, other participants in the foreign exchanges have minimised their euro exposure, then the threat to its purchasing power is in the hands of the euro-area population.
It is possible that one or more Eurozone nations will decide to drop the euro and return to a national currency. Individual nations have been unable to issue their own currencies to supplement taxes and devalue their debts, so the wish for a return to national currencies has a practical purpose. The desire to avoid the consequences of this happening has doubtless encouraged capital flight from the Mediterranean countries into the relative safety of the German banking system.
Flight capital has moved in this way ever since the financial crisis of 2008/09. Unfortunately, the amounts are now so large that no Eurozone jurisdiction can be said to be financially stable. What amounts to a systemic run on the weaker members of Eurozone banking system is deliberately concealed by the ECB’s intra-jurisdiction settlement system, TARGET2.
The chart below is of the TARGET2 imbalances between the Eurozone’s national central banks, which at the end of February totalled a record €1.08 trillion, easily surpassing the previous crisis level of mid-2012.
One cannot say that these imbalances are a direct measure of capital flight, but it is accurate to state that they arise from the depositor shortfalls in banks losing deposits, to the extent they are being covered by the relevant national central banks. For example, if Santander in Spain suffers a net withdrawal from its customer deposits, the balance sheet shortfall is financed by the Banco de España, and the Banco de España’s balance sheet will reflect the shortfall instead of Santander’s. Hence the deficit within the settlement system. Equally, if Commerzbank has an accumulation of deposits from Spain, those excess deposits will be reflected by Commerzbank increasing its reserves at the Bundesbank. The Bundesbank’s liability to Commerzbank is covered by a matching credit in its TARGET2 balance.
In effect, the ECB is using the settlement system to conceal the scale of capital flight. The fact that these imbalances are escalating again, with Germany’s unsettled balance rising sharply into record territory (€814.4bn at end-February) must therefore be a serious cause for concern.ii
A recent development is the appearance of a deficit on the ECB’s own books of €178bn, which, according to the ECB, has arisen from purchases through the ECB’s Asset Purchase Programme. When the Euro-system buys assets from credit institutions, they are bought through the relevant national central banks, with the payment owed to them by the ECB through TARGET2. A credit is thrown up on the balance sheet of the relevant national central bank, reducing its TARGET2 deficit, or increasing its surplus if it has one.
The assets submitted for repurchase are unlikely to be high quality collateral, such as German bunds, but much more likely to be lower-quality assets. This is because the pace of debt issuance by the more indebted governments continues at a high pace, relative to that of Germany, which is in budget surplus and whose debt issuance is minimal in comparison. Furthermore, high quality assets are required as collateral in shadow banking operations, so they are not readily supplied by banks in exchange for reserves. By way of confirmation of this analysis, according to Italy’s Mediobanca’s analysis, the ECB’s asset purchase programme effectively financed all Italy’s debt requirements last year, and has presumably gone a long way to bailing out other governments as well.iii
Therefore, the ECB’s TARGET2 deficit not only conceals the true scale of capital flight from France, Italy, Spain, Greece and Portugal, but it is integral to a government bail-out mechanism. The negative balances of the relevant central banks due to capital flight are therefore understated to the extent of most of the ECB’s negative TARGET2 balance of €178bn, and the assets acquired are at inflated prices.
The credits and deficits within TARGET2 first attracted public attention in 2012, particularly in Germany, where the Bundesbank appeared to be on the hook. The issue is now likely to resurface, with the Bundesbank’s surplus getting on for nearly a trillion euros. It is not actually the Bundesbank’s direct liability, because these credits and liabilities are the ECB’s, allowing the ECB to claim the disequilibrium is merely technical, totalling zero in its own balance sheet. This does not let the national central banks off the hook, with each national central bank having a predetermined liability for the ECB’s recapitalisation. Therefore, in the event of a default, the Bundesbank’s liability is set by its “capital key”, which is 27% of the total loss.
Tapering
As discussed above, the imbalances on TARGET2 do not fully reflect the scale of capital flight across the Eurozone, and it is difficult to see how these imbalances can normalise. The ECB has muddled through the enormous difficulties of recent years, deferring a major systemic crisis. This is what central banks are tasked to do, but there must always be a plan to return to normality. The ECB will make a start in this direction from this month, by reducing monthly asset purchases from €80bn to €60bn.
Tapering asset purchases amounts to reducing the support for indebted governments, so there are likely to be negative consequences. We have already seen yield spreads between bunds and other government bonds widen significantly in anticipation. Bond investors will have to assess the marginal rates the Italians et al will have to pay when forced to raise funds in the market with the ECB’s covert support reduced, and these rates will set future bond prices.
The greatest threat to someone in a debt trap is to have the interest cost rise. And not only does the cost of financing and refinancing maturing debt threaten to rise exponentially, but the debtor is increasingly forced into short-term funding. For this reason, rising interest rates are the beginning of the end for countries like Greece and Italy. The ECB’s first attempt to return towards normal monetary policies risks triggering a new sovereign debt crisis within the Eurozone.
These pressures on sovereign debtors coincide with the Brexit problem and America turning her back on the EU project. Future historians will presumably conclude that Brexit triggered a crisis that led to the demise of the European commission. This would be incorrect. The problems are entirely of the project’s own making.
The ECB is running out of options in its battle to keep the Eurozone from collapsing. The only tool the ECB has left to defray this inevitability is yet more monetary expansion, which will eventually undermine the euro. When that happens, those that have moved their deposits from too-big-to-fail banks in Italy, Spain and elsewhere into the German, Luxembourg and the Dutch banks will have found only temporary respite. As with all bad ideas, the EU and its currency will find monetary or systemic collapse is the final consequence of all constructions founded on fallacious expediency.
And finally, gold
We return to that article in the FT, about the reserve asset managers at central banks who have eliminated their euro positions. Presumably, their analysis echoes the conclusions of this article. But taking the euro out of their reserves leaves them with a problem: what to put in its place.
Primarily, the objective of holding non-dollar reserves is diversification from the dollar, and since the euro is a major component of the dollar’s trade weighted index, it is a big hole to fill. Some of them have opted for sterling, which is a vote of confidence for Britain in a post-Brexit world. Others, particularly the Asian central banks, are likely to be adding to their gold holdings, being the ultimate dollar hedge.
When EU nationals begin to understand the banking and currency dangers faced by the Eurozone, there is little doubt they will increase their holdings of physical cash and gold. Anything to get out of the banking system.
i.From Brussels, With Love, by Dr Radomir Tylecote and Sir William Cash, Duckworth. pp20.
ii.The figures in the chart, prepared by Osnabrück University, are of monthly averages to January. The February figures are taken from the ECB’s database and are for month-end. These are available on http://sdw.ecb.europa.eu/reports.do?node=1000004859.
iii.See http://marcello.minenna.it/wp-content/uploads/2017/01/Italy-2017-01-19.pdf
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