On October 28th, EUBusiness.com reported that there are expectations of another rate cut this year by the European Central Bank. The ECB will cut rates one more time if they believe it can keep the euro zone out of a deep economic recession.
The question of whether central banks, in Europe or America, should cut their interest rates is becoming hotter. The reason is painfully simple: the euro zone economy is standing still while individual member states are wrestling with budget problems. However, as I noted on October 18th, there are plenty of reasons why the ECB should refrain from further cuts. Rather than giving in to market pressure, the ECB should show monetary leadership and keep a tight leash on the euro zone’s money supply.
Table 1 tells us a great deal about why rates should remain where they are. It reports each country’s consolidated budget deficit (red figures) or surplus (black) as a percent of total government spending, over the past four quarters. In the second quarter of this year, 17 member states ran a budget deficit—as did the entire 20-member state euro zone:
Table 1
Table 1 is a scary read, but the numbers for the deficits are even scarier. In the second quarter of this year alone, the combined deficit for the euro zone’s member states was €105.6 billion; in total for the four quarters reported, the euro zone governments had to borrow €505.7 billion. This number gets even more frightening when we take into account that these deficits are neither new nor exceptional. Budget deficits have been a recurring problem in Europe over the past quarter century during the time the euro has existed. There were deficit problems before the euro zone, but one of the ideas behind unifying Europe economically was that a fiscal alignment would happen as the common currency was being rolled out.
The idea was that the budget discipline measures, written into the EU constitution as the Stability and Growth Pact’, would effectively force member states into fiscal discipline. As we know painfully well from the economic crisis 15 years ago, that did not happen—and here we are again.
With all this in mind, though, there does not seem to be much reason to worry about Europe’s deficits in the market for sovereign debt, at least not for the euro. In Figure 1, we can follow the yields (interest rates) on three different euro-denominated treasury bonds—the one-year, the ten-year, and the 30-year—from 2022 through 2023 and up to late October 2024.
After the rise in response to the ECB’s anti-inflation monetary tightening two years ago, yields have come down again, though only modestly. However, there is a piece of good news embedded in Figure 1, and it has to do with the green function representing one-year securities:
Figure 1
The so-called yield curve depicts the yields on all maturities of a nation’s (or currency area’s) government debt. A sound yield curve has low yields for short maturities and high yields for the longer ones; the longer you commit your money, the greater risk you take. Therefore, you should also be compensated more.
A sound, or normal, yield curve indicates that there are no particular inflation expectations in the market for euro zone government debt. This is good, because it means that investors can expect the debt market to remain stable over time.
The problem, though, is that Table 1 and Figure 1 are not long-term compatible. European governments cannot combine endless budget deficits with price stability. Somewhere along the way, the ECB is going to have to either raise interest rates and force governments into austerity—or start printing money to monetize the deficits again.
Since expectations in the debt market clearly suggest that European interest rates will continue to decline into 2025, there is neither a short-term nor a medium-term point where the ECB would start raising interest rates again. For this reason—and my European friends can dislike this all they want—the solution to the endless budget deficits is going to be another round of deficit monetization.
In short, the ECB will have to start printing money to buy government debt. When they do, it will be the third big wave of such deficit monetization since the euro was created almost 24 years ago.
A new wave of deficit monetization will bring about a new inflation episode. The fact that the market for euro-denominated debt currently does not expect such inflation is really of no consequence. More than likely, the investors have not factored in the fiscal and monetary mechanics that will bring monetary inflation back to the euro zone.
There is another aspect to euro zone interest rates and the relative calm they currently exhibit. Over on the other side of the Atlantic Ocean, longer yields on U.S. Treasury debt securities are rising. Figure 2 has the story:
Figure 2
This increase in yields is the result of growing concern among investors in the U.S. debt market that Congress will reach a point where it can no longer fully honor its debt obligations. While the government debt burden in the euro zone—significant as it is—is spread out over 20 countries, it is concentrated in one jurisdiction on the American side. This makes the inability of Congress to deal with its annual deficits all the more consequential.
In plain English: it is easier for one legislative body to bring about a bad fiscal crisis than it is for 20 of them to do the same.
At the same time, the rising U.S. debt yields will at some point force the euro zone debt yields to rise as well. Historically, there has been a conspicuous correlation between the two, with the U.S. acting as the driver and the euro zone as the passenger. Given the strong performance of the U.S. economy—at least in comparison to its European counterpart—there is a strict limit on how much of a yield gap investors will accept before they begin shunning European sovereign debt for U.S. Treasury securities.
When that happens—if not before—the ECB will be forced to raise interest rates instead.
Unless, of course, the euro zone member states have gotten their public finances in order by then.
