Is Europe headed toward another debt crisis?

In 2010, the Eurozone experienced a sovereign debt crisis that shook the world economy. Today, in the wake of the COVID-19 pandemic, it appears that the Eurozone could be well on the way to another such debt crisis.

It is not only that the public finances of several key countries in the Eurozone periphery are considerably worse than they were on the eve of the 2010 sovereign debt crisis. It is also that inflation has risen to a level that will make it difficult for the European Central Bank (ECB) to continue to keep the Eurozone periphery governments afloat by a continuation of bond purchases on the massive scale that it has been doing to date.

Italy, the Eurozone’s third-largest economy, provides a troubling illustration of the degree to which the public finances of the Eurozone periphery have deteriorated. Whereas in 2010, Italy’s public debt-to-GDP ratio was 120 percent, today that ratio is 150 percent, or at its highest level in that country’s 150-year history. Similarly, whereas in 2010, Italy was running a budget deficit of some 5 percent of GDP, today it is running one of around 10 percent of GDP.

Italy and the other countries in the Eurozone periphery have been fortunate that the deterioration in their public finances has coincided with the ECB buying government bonds on an unprecedented scale.

Over the past 18 months, in response to the pandemic and with a view to stimulating the European economy, the ECB increased the size of its balance sheet by more than $4 trillion. In addition, when buying government bonds, the ECB no longer felt constrained to buy its member countries’ bonds in direct proportion to their contributions to the ECB’s capital account. Rather, it felt free to buy the government bonds of those countries most in need of its support.

As a result of the ECB’s massive bond-buying activities, the countries in the Eurozone periphery were spared having to go to the market to raise money at a time that their public finances were in disarray. Instead, they found that not only was the ECB bond buying sufficient to finance their large government budget deficits. It was also sufficient to cover their gross government financing needs. 

As a result, despite these countries’ poor public finance positions, their market government bond yields have remained relatively low and not appreciably above corresponding German government bond rates.  

The fly in the ointment for countries such as Italy and Spain is that they cannot expect that the ECB will continue to buy their bonds on a large scale forever. This could prove to be particularly problematical since these countries’ past poor economic growth performance within the Euro straitjacket, which precludes currency devaluation to promote exports, does not offer hope that they will be able to grow their way out from under their public debt mountains.

One reason to fear that the end of the ECB’s massive bond-buying program might be in sight is the unwelcome rise in European inflation. Over the past 12 months, Eurozone inflation has been running at 4 percent or at double the ECB’s inflation target. Meanwhile, German inflation is running at 4.5 percent. This is prompting the German tabloids to dub ECB President Christine Lagarde as “Madam Inflation.” It is also heightening traditional German angst about inflation.

Another reason to fear an early end to the ECB’s massive bond-buying program is the strong resistance to such bond buying by the Eurozone’s northern member countries in general and by Germany in particular. These countries view the ECB’s bond-buying activities as a move to a fiscal union through the backdoor, which they believe is in violation of the spirit, if not the letter, of the Lisbon Treaty.  

In 2010, the Eurozone sovereign debt crisis caught both world economic policymakers and markets flatfooted. With so many clues now pointing to another round of the Eurozone debt crisis next year, when the ECB music of easy money is likely to stop playing, the same should not occur this time around.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.