Is Europe headed for a new debt crisis?
In 2010, the Eurozone experienced a sovereign debt crisis that shook the global economy. Now, in the wake of the COVID-19 pandemic, it looks like the Eurozone may well be on the way to another debt crisis.
It is not just that the public finances of several key eurozone periphery countries are much worse than they were on the eve of the 2010 sovereign debt crisis. It is also that the inflation has reached a level that will make it difficult for the European Central Bank (ECB) to continue to keep governments in the eurozone periphery afloat by continuing the large-scale bond purchases it has been making until here.
Italy, the euro zone’s third largest economy, provides a disturbing illustration of the degree of deterioration in public finances in the periphery of the euro zone. Whereas in 2010, Italy’s public debt/GDP ratio was 120%, this ratio is now 150%, its highest level in the country’s 150-year history. Similarly, whereas in 2010 Italy had a budget deficit of around 5% of GDP, it now has one of around 10% of GDP.
Italy and the other peripheral eurozone countries were fortunate that the deterioration in their public finances coincided with the ECB’s purchase of government bonds on an unprecedented scale.
Over the past 18 months, in response to the pandemic and in an effort to stimulate the European economy, the ECB has increased the size of its balance sheet by more than $4 trillion. Moreover, when buying government bonds, the ECB no longer felt compelled to buy its member countries’ bonds in direct proportion to their contributions to the ECB’s capital account. On the contrary, she felt free to buy the government bonds of the countries that needed her support the most.
Thanks to the ECB’s massive bond-buying activities, peripheral eurozone countries were spared having to resort to the market to raise funds at a time when their public finances were in disarray. Instead, they found that not only the ECB’s bond purchases were sufficient to finance their large public budget deficits. It was also sufficient to cover their gross public financing needs.
As a result, despite the poor state of public finances in these countries, government bond yields in the market remained relatively low and not significantly higher than the corresponding rates for German government bonds.
The catch for countries like Italy and Spain is that they cannot expect the ECB to continue buying their bonds on a large scale indefinitely. This could prove particularly problematic since the poor past economic growth performance of these countries in the straightjacket of the euro, which prevents currency devaluation to promote exports, offers no hope that they will be able to get out from under their mountains of public debt.
One reason to fear that the end of the ECB’s massive bond-buying program is in sight is the unwelcome rise in European inflation. Over the past 12 months, Eurozone inflation has been 4%, double the ECB’s inflation target. Meanwhile, German inflation is running at 4.5%. This prompts German tabloids to dub ECB President Christine Lagarde as “Madame Inflation”. It also increases Germans’ traditional anxiety about inflation.
Another reason to fear a premature end to the ECB’s massive bond purchase program is the strong resistance to these bond purchases by the northern member countries of the euro zone in general and by Germany in particular. These countries see the ECB’s bond-buying activities as a transition to a backdoor fiscal union, which they say violates the spirit, if not the letter, of the Lisbon Treaty.
In 2010, the eurozone sovereign debt crisis caught global economic policymakers and markets by surprise. With so many clues now pointing to another Eurozone debt crisis next year, when the ECB’s easy money music should stop playing, the same should not happen this time- this.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was previously Deputy Director of the Policy Development and Review Department at the International Monetary Fund and Chief Emerging Markets Economic Strategist at Salomon Smith Barney.