By Douglas J. Elliott
This article was first published on June 16, 2020.
There is a serious risk of a sequel to the Euro Crisis that ran from roughly 2010 to 2015. The likelihood of such a crisis is hotly debated and depends on one’s views of a number of factors that are summarized in this paper. My own base case continues to be for some version of Euro Crisis 2.0 over the next two years, but recent positive developments may cause me to lower that probability somewhat below 50 percent.
This version of the crisis could begin at any time, since the underlying weaknesses exist and there are many potential triggers. The crisis would likely proceed more quickly than last time, given what has been learned from the first crisis and the economic and political tools that have been created. That said, it could still be a multi-year process.
What would this mean? Economic and financial conditions in Europe would be substantially more volatile and financial institutions could face major challenges, including the potential for a full-blown financial crisis in one or more countries. The effects would be smaller beyond Europe’s borders, but the economies of trading partners would be impacted, as would financial exposures of foreign institutions to Europe. There might also be opportunities for some of the big US banks to acquire European institutions that have been off-limits in normal times, not to mention opportunities to pick up market share through organic growth in Europe.
THE BIG PICTURE
Views about a potential new Euro Crisis depend primarily on how one weighs the positives and negatives of the Eurozone’s situation. I’ve broken the key points down into reasons for concern, reasons for hope, and the crucial questions that could tip the balance. For the "Euro Crisis 2.0" PDF version, please click here.
My own base case is that we have a Euro Crisis 2.0 that lasts for a couple of years, but that Europe once again works through it without a breakup of the Eurozone or other extreme outcomes. That would not make the crisis costless, though. Crises can pack a lot of pain into two years and there are likely to be at least mini-financial crises in one or more Eurozone member states if we do have the sovereign debt crisis.
There is a plausible scenario that is more optimistic, in which actions of the European Central Bank (ECB), national governments, and European institutions are sufficient to weather the storm without a real crisis. I may even elevate this to be my base case, if recent positive developments continue. Sadly, there is also a plausible scenario in which the Eurozone is badly shaken and one or more member states restructure their sovereign debt, with associated financial crises in the most affected nations.
These scenarios are somewhat correlated with pandemic scenarios, since worse health outcomes that lead to a deeper and longer recession would increase the pressures considerably. However, there are many European-specific factors that are not directly driven by the pandemic.
Reasons for concern
- Sovereign debt levels in many Eurozone countries exceed the levels of 2010
- Political environment is worse now
- Coronavirus Recession is worse than the Great Recession
- Corporate sector is overloaded with debt in many countries
Reasons for hope
- EU and Eurozone have more economic and financial tools now, and are using them
- There is considerable potential for further Eurozone integration in response to the crisis
- Interest rates are lower than in 2010
- Nature of the recession’s cause garners sympathy for weaker Eurozone countries
- How bad will the Coronavirus Recession be in Europe?
- How far will moves towards fiscal federalism go?
- How effectively has the Banking Union reduced the feedback loops between banks and sovereigns?
- How seriously will markets, and other stakeholders, take the threat of exits from the Euro?
- What will be the impact of the German Constitutional Court’s rulings on ECB’s powers?
Sovereign debt levels in many Eurozone countries exceed the levels of 2010. Italy has received the most attention. As an economy that is “Too Big to Fail,” the country has been hit horribly by COVID-19, and which will face many challenges in pulling out of the hole it is in. At the beginning of the Euro Crisis, Italy’s debt-to-GDP ratio was about 115 percent, versus 85 percent for the Eurozone as a whole. A decade later, Italy started 2020 at roughly 135 percent, while the Eurozone as a whole was only up to 86 percent. All of these figures will be considerably higher as a result of the pandemic.
Political environment is worse now. In the first years of the Euro Crisis, analysts and politicians were very concerned that voters would revolt if national leaders crossed various “red lines” that they or their predecessors had laid down. Yet, time after time, leaders were forced to cross those lines yet managed to do so without dramatic short-term political consequences. Arguably, the accumulation of these choices helped set off the populist/nationalist voter uprisings that came later, but leaders did find that they had the room to maneuver and that they needed to find compromises to hold the Eurozone together.
The picture in 2020 is quite different in much of the Eurozone. Populist and nationalist parties are much more powerful than in 2010 and even entered the government in Italy before falling out again. National leaders in the Eurozone are all watching carefully to try to avoid losing power to these populist parties and therefore will feel more constrained.
The Coronavirus Recession is worse than the Great Recession. The Global Financial Crisis and the ensuing Great Recession helped set up the first Euro Crisis by sharply worsening national budget deficits. The Coronavirus Recession is similarly harming government finances, only the increase in deficits is much sharper this time around. We do not yet know the full course of the recession, but the cumulative impact is very likely to be worse than in the Great Recession. My own view is that the most likely economic scenarios are worse than the market consensus, mostly because of the high risk of recurrences of the pandemic in many regions that could trigger strong containment measures again. The lockdowns would likely be milder and for shorter periods than was the case in the first wave, but most forecasts give too little weight to the risk of future waves.
The corporate sector is overloaded with debt in many countries. Partially as a result of monetary policies that made credit cheap and widely available, businesses around the globe took on additional debt since 2010. Europe is no exception.
This worsens the risk of a new Euro Crisis in several ways. First, it increases the drag on national economies, including by worsening unemployment. Second, it further harms budget deficits by reducing tax revenues and forcing larger rescue packages. Third, it creates non-performing loans that drag on the banking system, slowing the economy further and potentially requiring government-funded capital injections for the banks.
EU and Eurozone have more economic and financial tools now, and are using them. European institutions are in much better position in 2020 than they were in 2010 in terms of the policy tools available to them to fight against the disintegration of the Eurozone. The ECB has a range of tools that were created to fight the previous Euro Crisis and it is using these tools very actively now. The central bank has much more ability to buy government bonds of troubled Eurozone countries than was the case in 2010, although there are still political and, potentially, legal constraints. The ECB has also entered into a number of very large long-term refinancing operations (LTROs) for banks over the years. Collateral requirements to borrow from Eurozone central banks have also been eased considerably. Further, the European Stability Mechanism (ESM) was put in place during the Euro Crisis and is available to supply large amounts of funding for sovereigns, albeit with strings attached that can create political difficulties in accessing those funds. Various elements of the Banking Union have also been put into place, as discussed later.
There is considerable potential for further European integration in response to the crisis. In addition to policy tools that already exist, a number of methods for furthering European integration are being considered. Most importantly, President Emmanuel Macron of France and Chancellor Angela Merkel of Germany recently proposed a 500 billion euro Recovery Fund to be financed by borrowing in the EU’s name, to be repaid out of the EU’s own budget in future years. The European Commission took this even further and on May 27, 2020 proposed a 750 billion euro Recovery Fund, with a mix of grants and loans. This proposal is likely to be modified to some extent by the European Council (representing national governments) and the European Parliament, but I expect the broad outlines to be approved.
Any step of this nature would be a big move towards fiscal integration of the EU, since member states have not previously allowed debt financing of the EU budget. This would be an even bigger step if the EU is given the right to collect taxes to finance the debt, as opposed to relying on future contributions to the budget from the member states. The European Commission has proposed several taxes, including on digital activity.
Such a recovery fund, or other steps towards fiscal integration, would widen the ability of the EU to support member states that are particularly hard hit by the pandemic or, in the future, by other crises. This would spread the pain over a wider base and make it easier for national governments to cope with crises.
Interest rates are lower than in 2010. Debt levels are higher, but the cost of servicing the debt is lower, especially interest payments. This means that higher debt levels do not have as bad an impact on annual budget deficits. However, that may not help a great deal if the issue becomes one of investor confidence, which is likely to be tied to total debt levels and to the ability to sell new debt at reasonable rates.
Nature of the recession’s cause garners sympathy for weaker EZ countries. The public in richer Eurozone countries may prove more willing to allow actions to aid the weaker member states than
was true in the first Euro Crisis, due to the knowledge that a terrible pandemic is the cause of much of the economic and financial difficulties. The first time around, many voters in the richer
nations viewed the Greeks, Italians, and other Southern Europeans as suffering from the effects of their own profligate choices. This attitude poisoned the waters and made it more difficult to
reach consensus on aiding the troubled nations.
How bad will the Coronavirus Recession be in Europe? There remains a wide range of uncertainty about just how bad the recession will be, which will be a major factor in determining how much stress the Eurozone will face. A very bad recession would further reduce government revenues, require substantially larger outlays to support households and businesses, and put strong pressure on banking systems. One reason for the degree of my concern about the potential for Euro Crisis 2.0 is that both official sector and private market consensus economic forecasts appear to significantly understate the likely damage from the pandemic and the recession.
How far will moves towards fiscal federalism go? Many observers have noted from the Euro’s inception that monetary integration without fiscal integration is a somewhat fragile construct.
Sharing a currency across countries or regions only works well if either the economies are so similar that they are affected in the same way by any given shock or if there are adequate adjustment mechanisms to counteract the differential impacts. The Euro Crisis demonstrated that the lack of fiscal integration made adjustments much harder and therefore the EU took some modest steps, such as by creating the European Stability Mechanism (ESM).
The Recovery Fund proposal is a major step towards fiscal integration within Europe. If passed, it would represent the first time that the EU has borrowed against future revenue in the same
manner as nations do. Importantly, these funds would then be allocated to individual member states in proportions more reflective of their needs than of the size of their contributions to
the EU budget. Again, this is similar to how a nation like the United States would borrow or tax broadly and then allocate resources across its member states based on various criteria, including
the need for assistance.
The ability to borrow at the EU level and then allocate funds disproportionately among the member states gives Europe much more fiscal flexibility to deal with sovereign debt crises at the national level. At the extreme, this would make the creditworthiness of any member state essentially the same as the creditworthiness of the whole EU.
However, we will be far from this extreme case, which leaves us with three key questions. First, will the proposal become EU law and, if so, what modifications will be made in the process? It will be a shock at this point if something is not finalized that looks at least moderately close to the Commission’s proposal. Second, is this purely a one-off arrangement? The likelihood is that this precedent will make future deals of this nature much more possible, but there is a chance that this will be seen broadly as a one-off response to a once in a century health crisis. Third, and related, how strongly will “solidarity” within Europe hold? In the positive case, the EU and ECB policy responses will be seen as necessary and helpful, setting precedent for future actions. In the negative case, nationalist spirit or clear cases of EU funds being misused or frittered away on political pet projects or corruption could cause a rejection of this mechanism for the future.
How effectively has the Banking Union reduced the feedback loops between banks and sovereigns? A major problem in the Euro Crisis was the close connection between the strength of national governments and the strength of their banking sectors. Troubled countries saw big increases in their credit spreads and therefore interest rates, which hurt their local economies and slammed their banking systems. Banks that got into trouble undermined their local economies by pulling back on lending and they often needed rescues from their national governments, pushing up deficits. Europe responded by creating the European Banking Union, with institutions such as the Single Supervisory Mechanism, housed in the ECB, and the Single Resolution Board. This has worked successfully to improve the quality of regulation and supervision within the Banking Union and, combined with actions by other institutions, has substantially improved the resilience of national banking systems.
However, banks are still very closely tied to the fates of their national governments and economies. First, banks are inherently levered plays on the economies to which they lend and the national focus of most banks mean that they are hostage to the fortunes of their primary countries. Second, banks continue to be required to hold large quantities of government bonds, very largely those of the main country in which they operate. Therefore, when these bonds go down in value, the economic value of banks goes down, even if accounting principles may defer or obscure this reduction. Many stakeholders, including investors, respond to this economic hit, whatever the accounting shows.
Sadly, it seems clear that this bank/sovereign nexus is still a source of serious risk.
How seriously will markets, and other stakeholders, take the threat of exits from the Euro? Investors, lenders, and corporate managements have to take into account the potential for one or more nations to fall out of the Eurozone, switching to a new version of their old national currencies. Anyone investing or lending euros into a troubled country faces the risk that their euros will come back as lire or drachmas or some other national currency. Any country that switches out of the euro is highly likely to couple this change with a massive devaluation, in order to make debt levels bearable again. Further, the transition is guaranteed to be a rough one, even if it were to prove beneficial in the long run (which is by no means guaranteed).
My sense is that the redenomination risk is higher than in 2010 and that markets will perceive it that way. One can’t “unring the bell” now that it has become a serious topic of discussion, which it was not really at the beginning of the Euro Crisis. However, there is a reasonable counterargument that the Euro Crisis has demonstrated that even very unhappy countries will choose to stay in the Euro and that the other member states will do what it takes to ensure
What will be the impact of the German Constitutional Court’s rulings on ECB’s powers? Germany’s Constitutional Court, based in Karlsruhe, has ruled several times on the constitutionality, in Germany, of the ECB’s more assertive use of monetary and financial policies. Up until now, the rulings have laid down some constraints on the ECB, at least from a German point of view, but not ones that kept the ECB from pursuing its policies.
However, in early May of this year, the Court ruled more aggressively than before, including disregarding elements of a major ruling by the European Court of Justice on the basis that the reasoning was so flawed as to not be a legitimate, binding exercise of the European Court of Justice’s (ECJ) authority. (In general, the ECJ is the highest court of jurisdiction for issues concerning the actions of European institutions.) The Deutsche Bundesbank has been ordered
not to participate in some of the ECB’s policies if the ECB does not provide sufficient justification, in the Court’s eyes, within three months.
This is a very complicated issue which I cannot do justice to in a few paragraphs. My guess is that Europe will once again avail itself of the finest constitutional lawyers in the world and will find a way to work around the German court’s ruling without imperiling its policy objectives. However, I could be wrong and, in any event, this is illustrative of the types of constraints that could eventually keep the ECB from doing “whatever it takes” this time around. If the ECB were to be viewed by markets as hobbled in any serious way, it would seriously harm perceptions of the creditworthiness of the more fragile Eurozone member states, including Italy.
There is clearly a serious risk of a sequel to the Euro Crisis of 2010-2015. One’s views on the likelihood and severity will depend on how one balances a number of factors that increase or decrease the pressure. My own base case remains that there will be such a crisis, although I also expect Europe to come out the other end of such a crisis without extreme damage, such as a breakup of the Eurozone. That said, recent developments, such as the European Commission’s proposal for a 750 billion euro Recovery Fund, are promising and reduce the risks somewhat. If I revise my thinking in the near future, it will likely be towards greater optimism, although there are clearly substantial risks in any case.
Douglas Elliott is an Oliver Wyman partner focused on the intersection of Finance and public policy. He is the author of the book, Uncle Sam in Pinstripes: Evaluating US Federal Credit Programs. Prior to his current position, he was a scholar at the Brookings Institution and a Visiting Scholar at the IMF. Before that, he was the founder and principal researcher for the Center On Federal Financial Institutions. He began his career with two decades as an investment banker, primarily at JP Morgan.