Issues contributed:
Why we effectively already are in another debt crisis in the Eurozone?
What will the likely response of European leaders be?
Why the likelihood of the unravelling of the Eurozone is so high?
Earlier this year, my last (for now) academic article was published. It dealt with countries resorting to either sovereign debt defaults or IMF programs during economic crises. My coauthor was Olli Ropponen, currently a Chief Research Scientist at ETLA Economic Research.
Our main findings were:
The results indicate that in terms of the real economy, domestic defaults tend to be followed by losses, especially in developing countries facing crises. Defaulting on foreign liabilities yields an equivocal economic outcome depending mostly on the level of economic development. International Monetary Fund (IMF) programmes provide a more favourable crisis outcome.
The paper took more than five years to complete and in it we processed the data on 45 countries with a total of 857 annual crisis observations. It was a major undertaking.
One of the (unpublished) special sections dealt with the European debt crisis of 2010-2012. I’ll shortly summarize it here, while explaining we are effectively in another already. I end with thoughts how European leaders will respond.
The European debt crisis
The "European debt crisis" that rattled the world in 2010-2012, was, in essence, a large regional banking crisis. The 2008 financial crash constituted a 'sudden stop' to many weaker members of the Eurozone. Flow of private capital turned from speculative use in the periphery of the Eurozone to the safety of the stronger nations, like Germany and Finland, and Great Britain and the US globally. A capital flight from the peripheral countries of the Eurozone commenced.
In 2010, it was revealed that the public finances of Greece were on perilous ground. When joining the Eurozone, then Greek government had 'stirred up' its finances, with the help of Goldman Sachs to make an appearance for the euro entry. When it was revealed that the Greek government had more debt than it had notified, deposits started to flee the country. It needed foreign investors to fund its budget deficit of around 10.8 percent in GDP in 2010, and debt serciving costs (interest rates) started to soar.
European leaders thus faced a dilemma. Default of Greece would be likely to topple major European, mostly French, German and Greek, banks who had lend to the Greek government, and it would have been likely to lead to the exit of Greece from the Eurozone. Banks in the US had also provided credit default swaps against Greek government default. The US mutual funds had hundreds of billions of dollars invested in Europe's and especially French banks.
The possibility of contagion, that is, the crisis spreading to the banking sector of Europe and to other countries of the Eurozone as well as to the US was obvious. Default of one country could lead to speculation of further defaults and euro exits or even a collapse of the common currency, and the world had just recovered (partially) from the massive lack of trust in the banking sector during the GFC.
European leaders, with the support of the Obama administration, decided that the risk to the banking sector was too big and that the default of Greece should be averted. Thus, a governmental bailout, strictly forbidden in the Treaty of the Functioning of the European Union (TFEU) Article 125, was orchestrated.
On 2 May, 2010, the IMF and euro area governments decided to create a €110 billion rescue program for Greece. They also created an opaque European Financial Stability Facility, or EFSF, which was setup in 11 May 2010 and its operation was limited to maximum of three years. It was located in Luxembourg and it had the backing of all member states of the euro area. It sat outside the EU law, which, technically at least, allowed it to operate without breaking the TFEU. But, this did not calm the markets, why a permanent bailout mechanism, the European Stability Mechanism, or ESM, was agreed at the EU summit between 24 and 25 March 2011. It operated with a paid-in-equity of €80 billion, and issued bonds, but the euro area states were on the hook for €700 billion of losses in equity capital if necessary. That, fortunately, has never materialized.
In respond to the money from the bailout funds, Greece was forced to conduct extremely painful austerity measures. During one of the first bailout meetings, a representative of the IMF told the Greek representative that the only way for Greece to survive was through dismantling of her welfare state. But, the European leaders demanded that too. They could not tell their constituents that they're giving the money to Greece, mostly to bailout their own banks, with easy terms.
A massive lie, with the expence of ordinary Greeks, was orchestrated to save the already failed European common currency.
Where are we now?
The dire situation in the Eurozone is visible in the current debt levels.
The shares of government debt to GDP are now clearly above the “crisis levels” in 2010-2012. Howabout interest rates?
The Italian 10 -year bond yield peaked in around 6.8% in November 2011. The Greek 10 -year bond yield peaked at around whopping 36% in February 2012. The Spanish 10 -year bond yield peaked around 6.5% and the Portuguese 10 -year bond yield peaked at around 16% in January 2012.
Now, they are around 4.6%, 5.2%, 3.3% and 3.5%, respectively, so we should be fine, right? Unfortunately, no.
When the debt crisis truly started in September 2010, the Italian 10 -year bond yield was around 3.8%, the Greek bond yield was at around 5%. The Spanish bond yield was around 3.3% and the Portuguese 10 -year bond yield was around 4.7%.
So, yields are very close to those which enacted the crisis, debt levels are higher and the banks of the above mentioned countries are likely to be stronger only in paper.
And so, with the ECB seemingly committed of rising rates rapidly, another debt (banking) crisis in the Eurozone can flare up, practically, at any minute. At that point, the response of European authorities will be truly interesting to watch, but what is it likely to be?
The response?
I have to say that I am a little baffled, why European leaders did not start to push for the “energy crisis package” earlier. Now, while the discussion has started, it’s running late already.
The fact that the Recovery Fund passed Finnish parliament with margin of just 7 MP:s (from 200) in May 2021, is likely to have contributed to this.
I was very active organizing the resistance towards the Fund, and what I and our team heard, this “message” was delivered to other European leaders by no other than our then Finance Minister, Matti Vanhanen after our Parliament had accepted the Fund. Valdis Dombrovskis, an Executive Vice-President of the Commission and the Commissioner for Trade, also tweeted, right before the Finnish Parliament voted on the Recovery Fund that it would be “one-off” and “unique”.
There has probably been a heavy internal pressure within the EU against proposing a yet another fund, when it was promised to Finnish voters that the Recovery Fund would be something of an ‘exception to the rule’. This is probably the reason why the energy crisis package is already late, and all eyes are turning to the ECB.
One can imagine where Italian yields would already be without the ‘Transmission Protection Instrument’. In the TPI, the ECB uses the funds obtained from the rolling off of bonds of stronger Eurozone nations, like Germany and the Netherlands, to buy debt of the weaker nations, like Italy. This is effectively a ‘yield curve control’ operation, that is, a lending program of the ECB aimed at easing the fiscal burden of a member nation, strictly forbidden in the TFEU Article 123.
Still, as pressure on European bond markets will grow towards the winter and into next year, the TPI will almost surely become insufficient.
Then the ECB will be at a ‘cruxis point’. Will it let the euroarea to unravel or restart the QE (in full) risking runaway inflation? Previously my money would have been on the latter, but inflation and energy crises has changed things, somewhat.
They relate to the fact that exiting the euroarea, or practically any monetary union, is always a political choice.
Thus, all that is needed for the unraveling of the euroarea to commence, is for some government to decide that they are better off with their own currency and a central bank. This point is also likely to be much closer than many think.
While I consider most of the European political ‘elite’ corrupted in a sense that they unequivocally support further integration of the EU (while occasionally putting a ‘show’ againts it), their constituents do not. Usually politicians want to get re-elected and thus the democratic process could actually be the thing that kills the euro.
If (when) the pressure from energy prices and rapid inflation mount again in the winter, all that is needed for a popular uprising against the euro is that the media of some euro-country breaks the general narrative that “Putin did it” and starts (mostly correctly) blame the ECB for the inflation. At that point, all bets will be off, and the likelihood of the unravelling of the Eurozone would increase exponentially.
If the above occurs, the pressure towards the ECB to keep fighting inflation with higher rates would also grow massively. At that point, they may actually decide that they take their chances, keep rising rates and let politicians to decide on the fate of the euro. This would lead the European leaders to face the ‘mutiny’ againts further federalization of the EU in Finland.
It should be noted that the parliament of Finland accepted the government motion on the RF stating that the Recovery Fund would be “one-off” and “unique”. This was and is also the view of many leading Finnish economic experts. Thus, the passsing of the ‘Energy Fund’ could very well be halted in Finland. In that case the unravelling of the euro would almost surely commence.
Thus, I urge you to keep a close ear on any insurgent voices rising from within the euroarea in the coming months, as they can spell its demise.
Disclaimer:
The information contained herein is current as at the date of this entry. The information presented here is considered reliable, but its accuracy is not guaranteed. Changes may occur in the circumstances after the date of this entry and the information contained in this post may not hold true in the future.
No information contained in this entry should be construed as investment advice. Readers should always consult their own personal financial or investment advisor before making any investment decision, and readers using this post do so solely at their own risk. Readers must make an independent assessment of the risks involved and of the legal, tax, business, financial or other consequences of their actions. GnS Economics nor Tuomas Malinen cannot be held i) responsible for any decision taken, act or omission; or ii) liable for damages caused by such measures.