The economic concept behind the European Union (EU) forming was simple.

How do we get rid of the long customs lines of people and goods at border-crossings among the numerous European countries that were tightly located?

Freer movement of people, money and products is always good for economic gains. It is more efficient. Then they went one step further.

Why don’t we form a monetary union and have one currency? It sounded very logical. Plus, the added bonus of making a major currency that could compete with the US dollar gave the European countries another win.

But how they accomplished creating the EU was a mistake. Europe made a monetary union without a fiscal union. One became rigid and one remained somewhat discretionary. It’s like a group of friends agreeing to do a strict diet together but without any monitoring of what they ate or consideration of their dietary habits.

They concluded that “theoretically” it should work. This was a fatal assumption. It only works as long as every economy is growing and robust.

The long-run fiscal implications of demographic shifts and different degrees of social entitlements in various countries were not considered. Fast forward to now, where the imbalance is much more pervasive and institutionalized.

With this COVID-19 “virus crisis” induced demand collapse today, society is faced with what was once an unthinkable scenario. Where is the “reset” button?

Fighting Structural Imbalances with Cyclical Tools

The big and growing imbalances were very noticeable as early as 2008. Then the Great Financial Crisis happened. Like many economies around the world, the EU concocted a cyclical remedy for a structural ailment.

Twelve years after the short-term cyclical monetary stimulus that is now as permanent as some of the monuments in Europe, we have gigantic imbalances to deal with. Simply put, if the Italian government can borrow cheaper than the US government, do they have impetus to reform? Will they abandon internal political constituents to satisfy the European Monetary Union’s suggestions? I don’t think so.

The transmission mechanism through which the virus crisis will impact the global economy is through a demand shock. This is something we cannot afford to have. We already had a meaningful gap with supply being greater than demand.

We walked into this punch.

Do you feel a sense of déjà vu? You should; the quick and swift policy responses so far around the world have been from the same playbook that was used over the past 12 years.

Punish the savers and reward the borrowers. This has favored the build-up of over-supply relative to demand with no end in sight. How many more mega-malls do we need? What about automobile production capacity? How many more TVs does one need? Without the improvement in demand, the only thing we are doing is investing in an asset build up. In other words, increasing our liabilities and calling it growth.

Moral Hazard Maximus

I see the logic in why the EMU is buying all the government bonds in Europe. It is the most effective way to let the marginally weak governments keep borrowing to finance their deficit spending without capitalizing their onerous interest payment. Also, it is a very effective way to extend a lifeline to the marginal and credit-risky banks.

If this was done to help them overcome a short-term liquidity shock, as it was originally intended, I can see some merit to these actions. However, to continue for 12 years only to up the ante every time there is a global hiccup is reckless. Their action has created the mother of all moral hazards we have seen in modern time.

One key question at this juncture is what now? How do you eloquently unwind the mess? How do you withdraw the credit junkies from the zero interest rate nirvana?

Is there a “reset” button that you can use but not call it a default? It is very hard to address these structural issues in times of crisis like now, but it looks as though there are no painless options left for the EU.

Wait — The EMU can increase their balance sheet 4-fold again and reward the borrowers and punish the savers once more. Perhaps, this time though, the financial markets will see the diminishing benefit of these short-sighted policies and tell them—reset it or break it up.

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David Chon is a Korean-American from New York working in Hainan. He has over 30 years of global finance and investment experience. He is currently investing in businesses in China.

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