As a long-time friend of Greenleaf Trust specializing in foreign economic and financial markets, John Graham shares his global investment perspective as a guest contributor in this month’s Perspectives. John is a founding member of Rogge Global Partners headquartered in Great Britain and former head of JP Morgan’s Multicurrency Asset Management Practice in London.

Historians, at least in the near term, will struggle to pin a handle on 2020. It has been one of the most difficult and decisive years for decades. Its only potential rival might be 2008 with that year’s economic crash, though on reflection, 2008 lacked this year’s fractures in the social contract which have been so revealing and disturbing not just in the liberal democracies of the West, but in most nations with just a few, fascinating exceptions. For Europe in particular, the social contract and the European experiment have been tested like never before.

It is worth remembering that Brexit is not finished. Just now, the European Union and Britain are trying to hammer out a final divorce settlement. If no settlement is reached, then while the UK leaves the European Union without a trade agreement, Britain may be tempted to renegotiate or renege on its £37 billion separation payment. Oddly enough, though many of the trade issues between the two parties have been settled, fishing remains the big and hottest area of contention. The French are particularly keen for their fishermen not to lose access to Britain’s waters, a possibility in the case of a no deal departure.

Also, in the background of the current COVID crisis, is the ongoing push by countries in the East of the EU bloc toward less democratic governance. In Hungary, in particular, the creeping authoritarianism of the Viktor Orbán government finally came to full bloom at the end of March when he was handed full authority to rule with unlimited authority for an indefinite period of time. After years of muzzling the press, curbing judicial independence and restricting civil society activities, the Hungarian Parliament set in law what was already happening in real life. In response to Orbán’s behaviour, the EU has triggered Article 7, the constitutional mechanism which the EU can use to deal with EU governments which put the EU’s values at risk. However, due to internal EU politics, little has actually been done to roll out sanctions against Hungary.

Hungary’s neighbour Poland has also moved against the “rule of law.” Its Law and Justice Party has been steadily destroying the independent judiciary by placing the judiciary under party control and undermining an independent media. The Poles have consistently refused to accept the supremacy of European law over domestic law and have challenged the legitimacy of the European Court of Justice.

This drift towards authoritarianism has presented the EU with a big problem. The EU Charter of Fundamental Rights requires its members to maintain values which include democracy, human rights and freedoms, an independent media and rule of law No one, for various reasons, initially seemed willing to take on Orbán in Hungary and Andrzej Duda in Poland. (Orbán’s Fidesz party is part of the European People’s Party, the largest bloc in the European Parliament. Angela Merkel’s CDU is also a member). Article 7, mentioned above, removed some EU voting rights from the two countries but really provided for no significant sanctions. So here is one fork in the road for Europe. Does it, in spite of the Union’s stated aims and objectives, allow the rising tide of authoritarianism in the East to continue, or does it take a sharp stand in an attempt to bring Poland and Hungary (and those who might look to them as examples) back into line?

Enter COVID and the European Rescue Package. We don’t need to rehearse the dramatic impact COVID has had in Europe. While it, so far, hasn’t been as politically divisive as in the United States (though political divisions over the economics around COVID are rising sharply in the UK just now) the economic impact has been dramatic. The charts below show the projected sharp declines in GDP which are arising from the economic slowdown through a double whammy of reduced government income and fiscal stimulus designed to prevent mass unemployment. Readers of Perspectives will remember the threat of the Doom Loop in Italy, but the threat of cascading credit failure exists in other European countries as well.

The two charts below show the burden of debt that this shock to the economies of Europe will produce. Already high levels of debt will get much higher. All the countries of Southern Europe already have a debt to GDP ratio of over 100%. Given the uncertainties around COVID, it is reasonable also to assume that these debt ratios will be revised up.

Given the size of this economic shock, the EU moved this spring to develop a rescue package. The eventual proposal provided for the EU’s budget to increase from €1.1 trillion to €1.85 trillion over the next seven years. The extra €750 billion would be funded by borrowing through various entities including directly by the European Commission. This would be the first time that Europe, as an entity, would borrow funds directly in the market on this kind of scale. This gave rise to two questions:

How would the funds be dispersed?

Who would repay the borrowing?

The first question illuminates a second fork in the road for Europe. Heretofore, any funds normally dispersed by the EU have been paid back via the agreed formula for community-wide funding, largely GDP based. Rescue operations, such as that undertaken for Greece during the 2008 crisis, have been dispersed as loans to be repaid by the countries receiving the funds with dispersion supervised by the funding organizations (in the case of Greece, by the EU, the ECB and the IMF – The Troika). However, intense financial scrutiny of Greece and its reform program by the Troika produced a considerable backlash among the voting public, not just in Greece, but also in the rest of Southern Europe. The perceived “colonial” attitude of the Troika resonated with every anti-European and left-wing group in Europe. If another package were to be put together, the two leading countries in Europe, Germany and France, felt that the new facilities would have to work differently. Some of the funds would need to be grants meaning that the amounts repaid by any country would only be in proportion to their normal contribution to the EU budget i.e. the wealthier North would bail out the poorer South.

From the time the Euro was first suggested, through its launch and subsequent operation, many observers felt that the lack of a fiscal transfer mechanism could be its undoing. The lack of a mechanism for the EU bloc to transfer funds to parts of the system in need meant that poorer countries, deprived of currency devaluation as a way to address economic difficulties, had only fiscal spending and internal devaluation as a way of addressing economic problems. Over the years, this has proved very difficult to implement in liberal democracies. Many observers have concluded that it would be better for a central financing authority to provide funds to meet contingencies, as would happen in a single country or under a federal system as exists in the US. However, fiscal transfers in a single state mean that relatively wealthier areas of a nation provide subsidies for less well-off areas. These fiscal transfers do not happen as loans which need to be repaid. They are outright grants or targeted fiscal expenditures — roads, buildings, programs, et alia.

In Europe, the wealthier countries of the EU have been reluctant to “subsidise” the poorer areas. Where transfers occur, as in the case of the Greek bailout, they happen as loans which need to be repaid. Critics of this system argue that the need to repay large loans during a time of financial reform put a huge burden on countries which are already struggling economically. Moreover, the administration of these loans, sets up an “us vs. them” dynamic as is the case with the Troika. In Italy in particular, right-wing and populist movements have gained power by promising to fight against this dynamic. All across Southern Europe this spring, requests for a rescue package emerged as the impact of COVID became worse and worse. But the same governments who were requesting aid, were adamant that the aid should come in the form of grants, not loans.

As the negotiations over the question began in April and May, the second fork in the road for Europe became immediately clear. Nations lined up strongly either in favour of taking the more federalist approach or maintaining lending as the status quo. In particular, the so called Frugal Four, The Netherlands, Austria, Sweden and Denmark, came out strongly against extending grants to countries targeted to receive rescue funds. They clearly saw the precedent such a move would set and were opposed in principle to using their taxpayer Euros to bail out “less prudent” nations. On the other side, Italy and Spain argued vociferously that they would not take loans and be subject to Troika-like supervision going forward. They too understood that taking the grant giving road could lead Europe to a different dynamic, one that they favoured. In the middle of this sat France, who needed funds herself and Germany who was keen to avoid, at all costs, a North-South split in the Union. And, from the side lines, Poland and Hungary were busy trying to avoid having any provision in the package that would prohibit countries deemed in violation of the “Rule of Law” provisions of the EU Charter from receiving rescue funds.

So, Europe arrived at two forks in the road when all 27 countries gathered in Brussels in July to thrash out a deal. With Germany and France driving all parties to stay at the table, a deal was announced on July 24, with much relief and some triumphalism. Indeed, Europe has taken a step down the road to a more centralized financial system. The Frugal Four acquiesced when the amount of grant money in the deal in the €750 billion deal was cut from €500 billion to €390 billion and they were assured that this mechanism was being used on a one-off basis. The South was ecstatic that grant money would be forthcoming and a Troika-like system of supervision would be avoided (Italy will receive €65.5 billion and Spain will receive €59 billion of the Recovery and Resilience Facility). In the East, Poland and Hungary claimed victory as no specific provision for withholding funds for Charter violations was included. Nonetheless, Germany et alia are aware that something must be done to halt the spread of authoritarianism in the East. So, instead of spelling out clear rules, the rescue agreement allows the European Commission to propose methods to the Community for ensuring that the rescue funds don’t go to countries breaking those rules.

To observers from cultures where things happen more swiftly, the moves described above may not seem particularly revolutionary, however, given the glacial pace of change in the EU and its historical modus operandum this change in financing is significant. This type of facility will be called on again, one can be sure, and in a decade may be the standard operating procedure for the Community. One only has to think back to recent ECB innovations like negative interest rates and common funding for ESM bonds which were once “one offs”, but are now standard parts of the financial picture in Europe to see that borrowing by the European Commission on behalf of the Community as a whole will become common place. Which road the EU takes in regards to its members in the East is less obvious. Poland and Hungary have been playing a winning game against the centre for some time banking on a lack of will to do as they please. However, the centre, particularly the Commission and Germany are now determined halt the erosion of the rule of law in Poland and Hungary and, within the constraints of the Pandemic, are mobilizing their fellow nations do what needs to be done behalf of the liberal democratic ideals of the EU.

Investment Thoughts

It seems sensible to assume that, though the EU faces severe economic challenges, the step taken towards providing funds on a grant basis to nations in economic difficulty will make the EU stronger. There will still be arguments about this kind of operation in the future, but given the way the EU has operated since the beginning, this type of centralization will continue and is necessary to make the Euro a stronger currency. Moreover, the ability to make fiscal transfers to areas in need in the Community will strengthen the economy of Europe as a whole. European investments on the whole should look better after this year.

The coming confrontation with Hungary and Poland will be disruptive for those countries and will take a long time to resolve. Investment in those areas should be considered carefully.