By refusing to provide yet more cheap cash, the ECB has pushed the ball back to eurozone politicians, who are the only ones that can deliver the fiscal and political union needed to create an environment in which current account imbalances can be unwound and the crisis resolved.


We know what needs to be done

1) Bank union. Debt needs to be written down, and creditors need to share the consequences of bad lending along with the debtors. This means that some core region pension funds and banks may go under, but the risk of lending foolishly needs to be reasserted. A eurozone banking union, with a common regulator able to close banks and force restructurings and mergers, would ease the risk of a systemic bank crisis emerging.

2) Fiscal union. Further work must be done towards fiscal union, perhaps through the development of eurobonds, and the pooling of economic policy. This will create the second pillar, to complement monetary union, helping to transfer pools of wealth around the union.

3 )Political union. The founders of the euro shied away from fiscal union all those decades ago due to EU member states’ concerns over loss of sovereignty. But fiscal union cannot work without political union, since politicians must have a democratic mandate to transfer their voters’ money to other eurozone countries. Voters are no less concerned about loss of sovereignty today, but politicians need to persuade their voters to surrender national sovereignty if the euro project is to succeed.


What’s stopping fiscal and political union?

National interests and rivalries, with eurozone member countries broadly falling into two camps that are represented by the region’s two largest economies – France and Germany. It should be added that there is a general reluctance within the core region to accept that a persistent current account surplus is destabilising to a country’s trading partners.

Germany has always been relatively positive about closer political union within the EU. Arising from the on/off debate over the desirability of eurobonds, the German government’s current position is that it will consider moves towards fiscal union, if they come within an environment of closer political union. If German taxpayers are going to see their money transferred abroad, they must be able to have some say in how it is spent.

France has traditionally not wanted political union, and its current government has reiterated that position. With German economic power now morphing into political power, it has no wish to be a junior partner in a political union. Instead, its government proposes closer fiscal union first and if that succeeds, political union may follow.


Investment implications

The euro crisis, as well as fears of a double dip recession in the US and of a hard landing in China, all look like being a continuing feature of global capital markets, at least for the remainder of 2012. But despite these macro concerns, attractive valuations in asset classes such as equities and corporate bonds, deter us from going underweight in risk assets.

This is particularly the case in view of the relatively generous yields available compared to safe havens such as core government bonds. Instead, we focus on diversification of exposure to risk assets as a way of coping with market volatility, with dividends and interest being reinvested to boost capital return or used for income purposes.

Without closer union the outlook for the euro project is uncertain. Closer union brings with it political risk, but there is already a high political risk in the status quo as politicians look to the ECB to provide what can be only temporary palliatives to a structural problem arising from the incomplete creation of the euro. Draghi has done the right thing by doing very little. Investors should stay diversified and focus on yield.


Tom Elliott is a global strategist at J.P.Morgan. The views here are his own.