Facts
On July 14, 2022, Italy's Prime Minister Mario Draghi (former President of the European Central Bank) resigned, leading to a sharp decline in the Euro, which now equals the US dollar. The Euro was initially set at 1.18 to the US dollar in 1999 and reached as high as 1.6 US dollars after being freely traded.
Reflections
Draghi's Era
In 2011, during the Greek crisis, Draghi was appointed President of the European Central Bank. One of his first acts was to handle the Greek crisis, bringing a fragmented Europe back together.
In 2021, he became Italy's Prime Minister. Being the Italian Prime Minister has always been a tough job, especially since Italy is seen as a drag within the Eurozone. Italy often boasts without much contribution and cries out when they don't get what they feel is their due. (To note, PIGS = Portugal, Italy, Greece, Spain)
The official reason for his resignation was his opposition to a waste incineration plant, but the underlying issue I think is his inability to “exempt” Italy's insurmountable external debt.
Why Italy Chose Draghi as Prime Minister
Italy's debt has consistently exceeded its GDP. A debt below 80% is healthy, over 130% is risky, and above 150% is extremely risky (of course, Japan has always been over 220%). Over a decade, Italy surpassed 100% and kept rising, reaching 130% in 14 years. In essence, Italy's debt crisis seems beyond salvation.
The difference between Italy and Japan is that Japan can print its money to handle internal debt, while Italy can't print Euros, putting the burden on its citizens. Italy's leadership at that time tried to increase revenue and cut spending after 2014, but with little economic growth, the public grew resentful. In the 2018 elections, voters chose two ruling coalition parties, one against the elite and one against globalization and immigration. Their first move was to overturn almost all new policies of their predecessors, showing that Western countries can easily break promises. After the outbreak of COVID-19 in 2020, Italy issued 250 billion euros in national debt (notably, the debt is in Euros, so the cost is borne by the Eurozone). After this, the debt-to-GDP ratio soared to 160%.
The EU has a historical issue: once a member faces problems, they can't abandon them. This might stem from international trust or the short-term strategy of sticking together. Cases in point are Greece and Spain.
In my opinion, Italy's goal in appointing Draghi as Prime Minister was to find a way to avoid repaying the 250 billion euros, which might have been achievable due to the creation of a fund to aid Eurozone countries after COVID. The only issue was how much they could get.
(By the way, I believe analyzing foreign situations is much simpler than domestic or Asian contexts. Logical reasoning is often sufficient (No need to know what the leaders’ real thinking but in the end what they will do might possibly be deduced - since the data in developed countries are relatively more transparent). When analyzing China, Japan, Korea, Hong Kong, Taiwan, etc., one must consider a myriad of political factors and personalities. Even the style of different leaders should be intimately understood. For instance, Jiang Zemin supports policies like "Abenomics", but he also couldn’t be too aggressive in the south because there are even more high-ranking authorities there. This is somewhat similar to promoting tax-sharing reforms of the '90s, where the central government had to persuade each local government individually. When encountering powerful leadership like in Guangdong, even the Finance Minister was sent for negotiating since the leaders in Guangdong don’t even give a chance to other leaders from Beijing))
Current Situation
Since Draghi couldn't (or perhaps wouldn't) get funds, Italy grew frustrated with him. A major reason for this could be the Ukraine crisis.
Printing 200 billion euros wouldn't have been a big issue for the European Central Bank, but with the Russia-Ukraine conflict (Europe has always politically backed Ukraine) and the surge in commodity prices, Europe's inflation skyrocketed (as a side note, at least Europe's CPI includes energy, unlike the U.S.). Printing more money at this juncture would be akin to suicide. First, global confidence in the Euro has plummeted, leaving Europe both embarrassed and at a loss. Printing more money at this time is practically pushing the Euro to its demise. Second, if the Euro continues to depreciate, as an importing continent (except for Germany, but even Germany reported imports exceeding exports for the first time in decades), it would intensify the inflationary pressure. By then, resolving Italy's 200 billion problem won't be enough; it would be a credit issue concerning the whole of Europe and the Euro's reputation. (Europe's average inflation was 7.4% in April and 8.1% in May).
Therefore, printing money is not an option. In fact, to combat inflation, there's a need to start raising interest rates and tightening policies. Hence, not only can we not give money to Italy, but we also need to reclaim the money that was previously given. Both Draghi and the coalition parties understand this. So, when the party voted on the waste disposal station and abstained as a way to not support Draghi, it was only natural for Draghi to resign.
Talk about Factors Affecting Currency Value
After Draghi's resignation, the Euro fell below the 1-to-1 psychological barrier with the US dollar. Several elements determine a currency's value:
- National economy
- Amount of money printed
- Interest rate differences (If a country's government bond yields are high, money naturally flows there. Europe can be compared to the U.S. in terms of printing money and raising interest rates. However, it feels like Europe, possibly due to its system, might take more time to reach a consensus, hence always being slower than the U.S. On a side note, there's also a quantitative strategy based on anticipating European policies to be introduced later than those in the U.S., aiming to profit from something similar to arbitrage. In theory this arbitrage opportunity will always exist, because the efficiency in Europe is inherently lower. This inefficiency stems from the system, not from the people, as the system determines the number of countries voting, which inevitably takes time.)
- Psychological factors (crucial in the short term)
The Euro and Russia
It's important to mention that the core reason for the Euro's depreciation is Russia, not the US interest rates. By July, the Euro had devalued by double digits, with half of that happening in June, when energy crises were frequently reported.
As of the 23rd, Russia hasn't responded to cutting off Europe's natural gas supply. If they do, Germany's GDP could fall by 6%, and many European businesses would have costs two to three times that of their US counterparts, putting them at a significant disadvantage. In essence, large parts of Europe might enter a recession by year's end.
Currently, setting aside whether the Euro is still worth investing in, from a market perspective, everyone is anticipating a decline in the Euro. Maybe the question now is when and how this decline will occur. (Well maybe won’t happen? since Asia is even worse?)
EU's Biggest Issue
The EU's biggest problem is its collective nature. Under this collective system, when one country fails, others have to bail it out.
Establishing a unified Eurozone has benefited many countries. Most have profited from trade exchanges, including Italy. On the surface, Germany appears as the most economically advanced country, seemingly it is being taken more advantage of. However, in reality, Germany, taking advantage of the Eurozone's single large market and absence of tariffs, has aggressively dumped its products (such as cars) within the Eurozone.
The biggest issue with the EU is its collectivism. However, the fundamental economic problem under collectivism, in my opinion, lies in the lack of a unified fiscal system (this leads us back to the debate between market and non-market economies... both centralized and decentralized systems have their pros and cons, but currently in Europe, a decentralized fiscal system is extremely detrimental). While Europe can standardize its currency, it's challenging to unify fiscally (this is why countries like Italy can opt to issue Euro-denominated debt, expecting the European Central Bank and other countries to pick up the tab).
Every country is thinking (and has acted on) how they can benefit at the expense of others. Such maneuvers damage only the Euro itself, yet they indeed align with game theory (game theory is a vast topic, especially domestic games. A recent example would be how to inject funds into those unfinished buildings affected by the mortgage takers’ refusal to pay).
Brief Discussion on the Euro
In 1999, the Euro was introduced at a rate of 1.18 to the U.S. dollar and immediately began to devalue sharply. By 2002, the Euro appreciated significantly, primarily because it became the official currency of 12 countries, presenting a united Europe to the world.
This unity was essential for Europe to effectively compete in the era of globalization and gain the confidence of the international community.
However, today, the EU seems fragmented, with events like Brexit and the onslaught of COVID, casting doubts on its re-unification.
Potential Solutions for the Euro
Internal reasonable solutions: None. (Rampantly printing money might have even worse consequences than breaking apart, as it could mean the last shred of Europe's credibility. Unite again? Unlikely, unless there are more drastic measures such as isolationist policies, or even the unthinkable - war in Europe (though, in the short term, there seems no real possibility of conflict).)
My suggested solutions:
- Russia easing its regulations
- The U.S. Federal Reserve turning unexpectedly dovish
However, neither of these are within their control.
Predictions
- The Euro crisis remains unresolved. In 8-10 years, the use of the Euro will gradually decrease (or drastically reduce), and countries will revert to other solutions.
- Within 8-10 years, EU member states will in essence split. The number of special trade agreements between countries will skyrocket, with increasing tariffs.
- If China loses control of its CNY (if CNY destabilizes), Europe could face a decade-long recession or more, and by then, it might be treated as a dumping ground by the U.S. But I am not sure about this point.