Starry-eyed lovers in 18th-century England who faced opposition from their parents to their desire to be married often realized their dreams by crossing the border to Scotland at Gretna Green. Local laws at that time enabled the blacksmith to grant them matrimonial union amid the searing heat of the forge and across the same anvil where heated metal was shaped and bonded.
European nations similarly dream of union. In the 1983 Solemn Declaration on European Union, the heads of the governments of EU member states resolved to create a united Europe ... to work together to promote democracy ... to transform the whole complex of relations between (member states) into a European Union.
To succeed, this dream of a political union has to overcome trenchant resistance from nationalists in each member state opposed to the transfer of sovereignty from national parliaments to pan-European institutions.
The EU has been following its dream of a united Europe in the face of conservative nationalistic forces. When it took the decisive step to create the eurozone, the clash between the dream and the required devolution of sovereignty became inevitable.
Similar to the intense heat from the blacksmith's furnace, maybe the heat from market volatility will be able to bond together a true European Union as nations are forced to devolve sovereignty over fiscal policy to eurozone institutions. For investors, this might be a good result in the longer term, with the added stability of a truly unified Europe reducing the volatility seen across asset classes, and investors better placed to invest with increased confidence and control, away from the significant impact caused by the macroeconomic concerns within the eurozone. In the near term, however, market risks remain high, with investors continuing to seek returns in markets where there are few places to hide from the storm.
For many years, the European project concentrated on economic integration, where issues of national sovereignty were not generally at stake, thereby defusing this resistance. The EU now includes 27 European nations. It has achieved impressive economic integration, allowing for duty-free trading among members and maintaining a high degree of labor mobility.
In addition, the EU includes institutions that create the illusion of a politically integrated entity. It has an executive branch, the European Commission with a president; a directly elected legislative branch, the European Parliament; and a European judicial system. It also includes the important Council of the European Union made up of government representatives of each EU nation. A subset of the council, the Eurogroup, consists of only eurozone members.
Unfortunately, these pan-European entities have little direct power, which still rests with the national legislatures. This was generally satisfactory before the establishment of a single currency zone. The eurozone, however, created the need for genuine transfer of sovereignty. One major achievement was the devolution of control over monetary policy to the European Central Bank.
The devolution of sovereignty to pan-European institutions stalled over fiscal policy, however. The 1997 Stability and Growth Pact aimed to transfer to the European Commission and to the European Union an important degree of control over fiscal policy, constraining member nation budget deficits. It failed because core eurozone nations Germany and France violated the agreement not long after it was signed. They ran deficits that exceeded the pact's limit and suffered no penalty, even though they were theoretically liable for large fines.
The failure of the Stability and Growth Pact shows the eurozone has no effective enforcement mechanism to force its member states to turn over control of their fiscal policy to a pan-European body. It turns out the only mechanism that can force this is the market itself.
The economic crisis that began outside of Europe in 2008 brutally drove up deficits and debt levels in the eurozone. Eurozone members that had not exercised enough control over their fiscal policy or where their banking systems suffered major losses were forced to ask for help. This was because the financial markets had refused to finance any more of their sovereign debt or would do so only at prohibitively high and unsustainable interest rates.
The eurozone, in conjunction with the International Monetary Fund, was ready to help, but in return it required substantial concessions of national sovereignty. Greece, Ireland and Portugal were forced by financial markets to accept stringent austerity programs including budget cuts, public-sector layoff plans and tax increases in return for their debt bailouts.
It is quite possible that the eurozone-initiated debt crisis plan for Greece will fail. This is because the creditor nations have strong doubts the agreed-upon programs will, in fact, be implemented. German Finance Minister Wolfgang Schaeuble said, If you can spend money on my tab, you won't be thrifty.
Moreover, the Greek electorate fears the programs are too severe and will not work to their benefit. This view might be correct. The Greek economy declined by an estimated 6.5% annual rate in the first quarter of 2012. The fall in economic growth might be so large the budget deficit cannot be reduced through further austerity. The governing coalition appears fragile and the second-largest party platform calls for a major renegotiation of the austerity plan.
The prospects for the ultimate success of bailout plans in Ireland and Portugal are better. Nonetheless, the challenge for the eurozone is to implement its fiscal policy recommendations without requiring the financial markets to act as the enforcement mechanism that forces members with weak fiscal policy into a bailout program. This can be done only by changing each member's national statutes or constitution to give properly agreed eurozone fiscal policies the force of law in each member state.
The controversial fiscal pact signed by 25 of 27 EU countries in January but ratified by only five countries so far is an important step in this direction. It requires each eurozone member nation parliament to enact legislation that mandates a balanced budget with penalties enforceable by the national judicial system. Moreover, the pact requires each eurozone member to give the European Court of Justice jurisdiction to review budget deficits.
Events in Europe continue to provide a focal point for regional and global investors. The impact of macro events on market confidence will result in an ever-changing and challenging environment. While a more integrated Europe will provide stronger foundations, uncertainty will continue to dominate until suitable and far-reaching economic, social and political policy responses can be agreed upon and implemented. n
Andrew Harmstone is portfolio manager for the global macro and asset allocation team at Morgan Stanley Investment Management Ltd., London.