Is the euro area entering another sovereign-debt crisis? Indebted Italy must pay 1.9 percentage points more than Germany to borrow for ten years, nearly double the spread at the start of 2021. The borrowing costs of Spain, Portugal and even France are up sharply, too—and spreads were even higher before the European Central Bank promised on June 15th and 16th to turn the tide. As in the nightmares of 2012, the central bank is working on a plan for bond-buying to prevent weak countries from spiralling towards default. Echoing Mario Draghi’s promise to do “whatever it takes” to save the euro area, Christine Lagarde, president of the ecb, warned on June 20th that anyone doubting the central bank’s resolve would be “making a big mistake”.
The ecb’s pledges should forestall a crisis for the time being. Yet be in no doubt, in the long run simply depending on the central bank to underwrite the debts of the euro zone’s governments leaves the currency union intolerably fragile.
Having spent $2trn supporting its economies through the pandemic, Europe is more indebted than it was a decade ago. Italy, the bloc’s third-largest economy, has towering net debts worth nearly 140% of its gdp, up from 108% at the start of the previous euro crisis in 2010. France’s balance-sheet looks almost as dodgy as Italy’s did after the global financial crisis. High inflation will ease the burden somewhat this year. But as the ecb raises interest rates to get inflation down, the cost of servicing what remains will rise.
High interest rates take time to make themselves felt in countries’ budgets: Italy’s outstanding debt has an average remaining tenor of almost eight years. The lag creates time for the ecb to prevent a crisis in which fears of default become self-fulfilling by raising borrowing costs. The central bank is used to walking the line between preventing runs and giving spendthrift countries an incentive to incur debts at its expense. As in the 2010s, it will undertake to contain spreads, but its help will probably come with strings attached.
The ecb also has a formidable new problem to solve: working out how to fight inflation and support indebted countries at the same time. In most of the 2010s and early in the pandemic the bank could justify buying Italian or Portuguese bonds partly because that was also a helpful economic stimulus. Inflation was below its 2% target. Now, by contrast, it is throwing cold water on the economy by raising interest rates, so it must justify any bond-market interventions solely on the basis of fighting financial fragmentation. Their stimulative effect is unhelpful.
To square the circle the ecb may “sterilise” the effect of bond-buying on the banking system, by using other instruments to soak up the money that its purchases inject. Yet sterilisation is only a partial solution. Higher spreads for weaker borrowers are a natural consequence of monetary policy, so suppressing them blunts the effect of interest-rate rises. The stimulus may be small, but its mere existence at a time when inflation is too high would make bond-buying harder to defend in court when hawks challenge its legality—as they inevitably will.
En garde Lagarde
The biggest threat is that containing spreads will not be enough to protect vulnerable economies. Investors expect the ecb to raise interest rates to 2% by the end of the year. As a result even rock-solid Germany, which by definition pays zero spread, is now charged 1.8% to borrow for ten years, up from -0.5% less than a year ago. If rates were to rise further, Italy would start to look wobbly, even if spreads could be contained at their current level. The country probably cannot tolerate yields on its bonds much above 4%. Around that point, the goals of price stability and defending indebted countries would become irreconcilable.
Should interest rates surge, the euro area would look dangerously frail. The only way to make it safe is fiscal and financial integration that relieves the burden on the ecb. One part of that is breaking the “doom loop” running between indebted sovereigns and the local banks that own their debt—a project that has seen some progress. Yet even if Italy’s banks could withstand an Italian default, European policymakers would never countenance throwing a €2trn bond market to the wolves. Hence the contradiction between monetary union and fiscal separation would remain unresolved.
And the only fix is more collective spending by the euro zone countries. The €750bn “Next Generation” fund, born during the pandemic and financed by joint borrowing, is already doling out cash, which should reduce pressure on national budgets. The more spending is centralised, the easier it will be for indebted states to run the surpluses that may be necessary for their debts to be sustainable if interest rates rise. Many in Europe will not like the transfers from north to south that result. But such are the flaws in the currency union that the alternatives—fragility and inflation—may be even worse. ■
