The collapse of the French government over a belt-tightening spat earlier this month has traumatized more than just the country’s political elite.
To many, it was an uncomfortable reminder that Europe’s debt problems, while they may have been overshadowed by other crises in recent years, have never really gone away. And whereas that vulnerability was confined mainly to the edges of the eurozone 15 years ago, today it is lodged at its very heart.
The European Central Bank — not an institution generally given to alarmism — warned last month that the combination of high debt, yawning budget deficits and weak growth leaves the region open to a market crisis like the one that almost tore the continent apart in 2011-2012.
Yet the lessons learned last time around have helped to contain such fears so far. In the run-up to the no-confidence vote that toppled the government last week, market moves were significant, but orderly. France’s risk premium, or spread, over Germany rose to 0.90 percentage points — the most since 2012. But that was still far from the “big storm and very serious turbulence” that Prime Minister Michel Barnier predicted would greet his exit.
So were Barnier and the ECB just giving each other cover? European Banking Federation chief Wim Mijs suggests that sovereign debt crisis talk is little but political saber-rattling by President Emmanuel Marcon and his team. Politicians like to make “a choice between a stairway to heaven or a highway to hell,” he quipped.
This time is different
Equally, the firefighters who put out the blaze a decade ago argue that fears of a eurozone implosion are overblown — but admit that that may not stop a slow and painful European economic demise.
The big difference between now and 2010, they say, is experience. In 2010, nobody in the private or public sector had first-hand experience of a systemic banking crisis, and it was not thought impossible that a big bank or a European sovereign could go under. As a result, every new crisis appeared to be the trigger for the next one. Contagion was the watchword of the day.
“There was total institutional unpreparedness,” said Peter Praet, the ECB’s chief economist from 2011-2019.
Europe has since been busy preparing.
It created the European Stability Mechanism, a bailout fund for sovereigns, and endowed it with over €780 billion in paid-up and callable capital. It has entrusted supervision of any bank big enough to cause problems beyond its home country to the ECB, and created the Single Resolution Board to oversee any regionally significant bank failure. At the same time, the ECB has developed two new instruments explicitly to stop the kind of contagion that made the 2010-2013 crisis so virulent.
Neither Mario Draghi’s Outright Monetary Transactions nor Christine Lagarde’s Transmission Protection Instrument have been used, but their mere existence means that anyone wanting to speculate on a eurozone break-up must have very, very deep pockets.
But more important than any individual response is that the last crisis experience created “a political understanding that problems need to be dealt with in an efficient way, collaborative way” and the ability to agree a response “more easily and quickly” in future, said Patrick Honohan, the central banker who led Ireland through the collapse of its banking system and the subsequent sovereign bailout. “The experience is there. We have done it.”
In other words, today’s starting point is the assumption that Europe will do, in Draghi’s phrase “whatever it takes” to preserve the euro. Contagion, and crisis, only become possible when market belief in that falters.
At least in some respects, mustering the necessary political will should be even easier today as everyone faces the same challenges that require massive investments, argued Honohan, pointing to the fact that even Germany is considering easing its tough spending rules.
“There’s no split between creditor and debtor countries like there was in Europe in the last debt crisis,” he said. “Since everybody is in the same boat today, Europe is likely to pull together.”
Only, some in the boat are baling and paddling more vigorously than others. As Bank of France Governor François Villeroy de Galhau told a radio interviewer recently, France is alone in not having made the reforms that many of its neighbors (“even the Italians!”) have made since the last crisis. And, while political will at the top of the EU pyramid is solid enough, Barnier’s government fell precisely because the opposition majority in parliament — playing to their respective bases — refused to endorse them.
Marcel Fratzscher, head of the Berlin-based German Institute for Economic Research (DIW) warned that the multiple-whammy of crises has left people poorer than they would otherwise be and fed support for populist parties. That in turn has paralysed the political process and is now preventing much-needed reforms.
Bank-sovereign nexus weakened
To Vitor Constancio, who served as ECB vice-president through most of the eurozone debt crisis, the main difference between now and 2010 is that the banking sector is now much more resilient, posing little risk to the economy and the public coffers. Across the largest banks in the region, the so-called CET1 capital ratio — a benchmark for financial strength — has risen to over 15 percent from below 13 percent when the ECB took over as supervisor in 2014.
That’s important given how insidiously the bank-sovereign nexus worked last time around. The sovereign debt crisis was preceded by the Global Financial Crisis, in which banks’ massive losses necessitated capital injections and guarantees from governments which, ultimately, couldn’t afford them. Then, when governments needed the money, the banks they had traditionally relied on to buy their bonds a crisis couldn’t oblige.
But while bank balance sheets have strengthened, public ones have weakened, due to a lost decade of growth and a succession of economic shocks. The aggregate deterioration has been relatively modest: gross government debt has only risen from 83 percent on the eve of the sovereign debt crisis to 88.1 percent as of the middle of this year. But that masks a sharp deterioration in France, where debt has risen to 110 percent of GDP from 89 percent in 2010.
It could be worse. Praet argued that, while French public debt is clearly too high, the country is facing a political crisis, not a solvency crisis. At least in the short term, “there are no doubts that France can finance its budget,” he said.
This explains why France’s risk premium over Germany has remained below 100 basis points — a small fraction of the 2,700 basis points Greece had to pay in 2012, and nowhere near even the 200 basis points that Italy had to dish out last year when the ECB’s policy tightening course spooked investors.
But the trajectory — and the inability to alter it — are a big worry.
“The latest political developments [in France] will further undermine the country’s growth dynamics while increasing the borrowing costs for the government, companies, and households,” said Allianz chief economic advisor Mohammed El-Erian.
“Together with political developments in Germany, this will create stronger headwinds to growth in the euro area, undermine responsive policymaking at a crucial time for competitiveness and productivity, and weaken the EU’s negotiating stance vis-à-vis the incoming US Administration.”
In all, instead of a 2010-style blowout, the big worry is that of a ‘slow burn’ decline, albeit one that remains capable of flaring up into something worse any time there is an external shock.
“One should never exclude that severe market stress could pop-up,” Praet warned. “We have seen that in the U.K. and even in the U.S. Treasury market.”
EFG Bank chief economist Stefan Gerlach put it more bluntly: “Having a large public debt is like driving drunk. Sooner or later, you will have an accident. The question is just how severe it will be.”
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