Europe’s financial position is still perilous years after the debt crisis
David Brown says the apparent stability of the European Union masks the heavy debt levels of its member countries, which were only propped up by decisive action from Germany and the ECB that may not be there next time around
Global markets seem to have sunk into a collective amnesia over problems which have dogged the euro and European financial stability for years. The single currency might have plateaued out around the US$1.20 mark versus the US dollar, but the euro’s failure to make stronger gains out of the dollar’s recent troubles reveal underlying relative weakness. The euro’s inability to win over investors in a bigger way will come back to haunt it.
Europe’s economy seems to have recovered from the dark days of the 2008 global downturn and Europe’s debt default crisis, which took the euro and European monetary union to the brink of collapse. But this has been possible only through massive intervention from the European Central Bank, riding to the rescue with negative interest rates and the bank’s €2.5 trillion (US$3 trillion) asset purchase programme. Whether the euro zone can stand on its own two feet once the ECB’s special measures end is still open to doubt.
European central bankers have successfully papered over the cracks while financial markets have suffered a massive memory lapse. Germany’s recovery might seem copper-bottomed but there are still too many zombie economies in the euro zone living off the ECB’s monetary steroids. Debt deflation and fiscal austerity still rip great holes in aggregate demand, with euro zone inflation serially undershooting targets while unemployment remains far too high.
Europe’s policymakers are grasping at straws if they truly believe they can “grow” their way out the problem. Risks to European financial stability are still deeply ingrained. The dangerous build-up of European debt will not disappear overnight.
Of course, the problem is not just the explosion of European government debt. The ECB may hold the fort for distressed economies via its government bond support operations but the build-up of private-sector debt, especially in the financial sector, is pushing Europe into the danger zone.
Italy’s eye-watering public debt problem is made worse by the burden of bad debts that are also crippling its banking sector. Italian credit default risk is the elephant in the room, containable while the positive mood persists, but would be the debt crisis from hell in a wider market meltdown. It could even be potentially indefensible, overwhelming the ECB’s limited market support capability and throwing the euro zone back into chaos and existential crisis.
Ultra-low levels of interest rates and yields also pose serious risks for European financial stability. In Germany, the savings market remains hamstrung by much of the government yield curve steeped in negative territory and 10-year government bond yields offering as little as 0.6 per cent to investors. It is a dire problem for the pensions and life assurance industry used to offering guaranteed investor returns of 5 per cent in the past.
Increasingly, German investment companies are being forced into higher-risk securities to bulk up investor returns, the same problem which hit the German banking and pensions industry in the run-up to the 2009 European crisis. When German Chancellor Angela Merkel first considered taking a hard line on a European bailout, it was only the dawning realisation of Germany’s dire exposure to high-risk investments in southern Europe which caused her to change her tune.
Europe only survived the crisis due to ECB quick thinking, backed up by huge support from the German government. Given the changing political tide happening in Germany right now, this is no longer a guaranteed last line of defence.
Germany is hoping for higher interest rates and bond yields as a prelude to higher euro zone inflation, set against a backdrop of rising rates and yields in the United States. But it is grasping at straws while European inflation remains stubbornly below the ECB’s 2 per cent target and Germany’s safe-haven appeal keeps bond yields depressed well below equivalent US levels.
Under the surface, Europe is still a mess. Too much has been swept under the carpet without tackling deep-rooted problems. It means underlying financial instability will return to haunt the euro with a vengeance at some stage in future.
David Brown is chief executive of New View Economics