In 2010, the euro area experienced a sovereign debt crisis that shook the global economy. Today, in the wake of the COVID-19 pandemic, it looks like the eurozone may be on track for another debt crisis.
It is not only that the public finances of several key countries in the periphery of the euro area are much worse than they were on the eve of the sovereign debt crisis of 2010. 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’s periphery afloat through continued massive bond purchases it has made until now.
Italy, the third largest economy in the euro zone, provides a disturbing illustration of the degree of deterioration in public finances in the periphery of the euro zone. While in 2010, Italy’s public debt-to-GDP ratio was 120%, this ratio is now 150%, its highest level in the country’s 150-year history. Likewise, while in 2010 Italy had a budget deficit of around 5% of GDP, today it has a deficit of around 10% of GDP.
Italy and the rest of the eurozone periphery were fortunate that the deterioration in their public finances coincided with the purchase of government bonds by the ECB on an unprecedented scale.
Over the past 18 months, in response to the pandemic and in a bid to stimulate the European economy, the ECB has increased the size of its balance sheet by more than $ 4 trillion. In addition, when buying government bonds, the ECB no longer felt compelled to buy bonds from its member countries in direct proportion to their contributions to the ECB’s capital account. On the contrary, he felt free to buy government bonds from the countries most in need of his support.
Thanks to the ECB’s massive bond buying activity, peripheral eurozone countries did not have to resort to the market to raise money at a time when their public finances were in dire straits. Instead, they found that not only the purchase of ECB bonds was enough to fund their large government budget deficits. It was also sufficient to cover their gross public financing needs.
As a result, despite the poor public finances of these countries, market government bond yields have remained relatively low and not significantly above the corresponding German government bond rates.
The problem for countries like Italy and Spain is that they can’t expect the ECB to keep buying their bonds on a large scale forever. This could prove particularly problematic because the poor economic growth performance of these countries in the past under the euro straitjacket, which prohibits devaluation of the currency to promote exports, does not give any hope that ‘they will be able to get out of 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, euro area inflation has stood at 4%, double the ECB’s inflation target. Meanwhile, German inflation is 4.5%. This prompts German tabloids to nickname ECB President Christine Lagarde as “Madame Inflation”. It also intensifies traditional German angst about inflation.
Another reason to fear a premature end to the ECB’s massive bond buying program is the strong resistance to these bond purchases by northern eurozone member countries in general and by Germany in particular. These countries see the ECB’s bond buying activities as a backdoor transition to fiscal union, which they say is in violation of the spirit, if not the letter, of the Lisbon Treaty.
In 2010, the euro area sovereign debt crisis caught global economic policymakers and markets unawares. With so many clues now pointing to another round of the eurozone debt crisis next year, when the ECB’s easy money music is likely to stop playing, the same shouldn’t. happen this time around.
Desmond Lachman is a senior researcher at the American Enterprise Institute. He was previously Deputy Director of the Policy Development and Review Department of the International Monetary Fund and Chief Emerging Market Economics Strategist at Salomon Smith Barney.