The European economy is finally showing some resiliency in its pandemic recovery. However, the comeback has not yet reached the large economies of Germany, Italy, and Spain, and is frail enough that even a small disturbance can disrupt it.
A new debt crisis is one of the most terrifying candidates for thwarting the recovery. So far, the warnings of such a crisis have mostly been cautious whispers in the background of the economy, but that is changing—and changing rapidly. With almost weekly signals that a new debt crisis is in the making, the bells of fiscal doom fall into ominous harmony with echoes from the Great Recession.
I have warned of a debt crisis in the making, and I recently noted that the world leaders who gathered in Davos in Switzerland paid no attention to it. I have also advised the Croatian government to learn all it can about the Greek debt crisis, so as not to end up in the same place when they join the euro zone in January.
Another analyst who has warned about a debt crisis is Tyler Durden over at Zerohedge. On June 8th, he pointed to the rapidly growing yield spreads on euro-denominated treasury bonds; two examples from his article: a buyer of a 10-year government bond issued by Greece gets a 2.55 percentage-point premium over a 10-year German bond; the premium for buying Italian debt for the same maturity is 2.1 percentage points.
When nobody wants to buy government debt
Normally, this kind of spike in yield spread would be the result of changes in the credit status of the governments involved. This, however, is not the case here: Greece has not recently suffered a credit downgrade. No, something more troubling is behind the rapid yield-spread rise.
This “something” is a deterioration of investor expectations: they are doing the numbers on the consequences of unending debt, stagnant economies (which means stagnant tax revenue) and—most recently—the effects of higher interest rates as central banks tighten their monetary policies. This adds up to a bad picture for deeply indebted governments: investors are growing worried about the ability of euro-zone governments to roll over their debt.
The failure to roll over debt may seem like a mere technicality, but where it happens, it wreaks havoc on government finances. It is known as a no-bid issuance of sovereign debt—in other words, no one wants to buy the latest pack of bonds that government puts on the market. This, in turn, means an acute cash crisis is just around the corner.
When we buy government debt in the form of a treasury bond, we lend the equivalent of the purchasing price to that government. The loan matures when the bond matures, at which point government must pay us back our money.
It can do so in two ways: by grabbing cash from its current inflow of tax revenue, or by selling another bond to someone, of the same or higher value. The former is known as “paying off your debt” while the latter is a debt rollover.
When investors start worrying that a government whose debt they own, may not pay back their money, and consequently refuse to buy more of that debt, a country’s credit rating will suffer. Governments know this, and few things make the manager of the public purse more nervous than the prospect of a no-bid issuance of debt.
It is, thankfully, a very rare occurrence, although the U.S. government got at least a whiff of experience with it recently when there were no bids—no buyers—for a new batch of MBS, or mortgage-backed U.S. Treasury securities. It was not until the interest rate on those bonds had increased significantly that investors purchased them at all.
Since this concerned mortgage-backed bonds—a small debt instrument by comparison—it did not have any lasting impact on U.S. Treasuries. However, the very fact that it could happen to any of the U.S. government’s debt instruments is in itself a warning sign.
It is also a serious reminder for Europe, which has already had a no-bid close call for its sovereign debt. A bit over a decade ago, during the Great Recession, the European Central Bank intervened on the euro-denominated sovereign-debt market for the express purpose of protecting euro-zone governments from a complete buyer walkout on their debt.
The ECB eliminated the no-bid threat by simply blowing massive amounts of money into the euro-zone economy. After an ad-hoc, put-out-fires approach to saving the euro-denominated bond market, in 2014 the central bank organized its monetary activism into two types of programs: one bought securities from the private sector, while the other concentrated on government debt.
The latter expanded rapidly: as of May this year, the Public Sector Purchase Programme, PSPP, owned €2.5 trillion worth of government debt. This equals 22% of all government debt in the euro zone.
They can’t do it again
The U.S. Federal Reserve has followed a similar path. It currently owns $5.8 trillion worth of Treasury securities, which is almost 20% of all U.S. government debt. The acquisition of all this debt has put the Fed and the ECB in a precarious situation going into the next debt crisis. In order to amass these assets, they had to print an enormous amount of money—so much, in fact, that they exhausted their ability to provide the economy with any more monetary stimulus.
Bluntly speaking: the central banks saved indebted governments a decade ago. They can’t do it again. The responsibility for saving Europe and America from the next debt crisis falls heavily on legislative shoulders.
They can do it: as I explain at the end of this essay, there are means at their disposal. What has been missing thus far is the will to act. The one thing they cannot do is rely on their central banks one more time. To see why, let us look at just how exhausted monetary policy has become.
The state of monetary policy is indicated by a central bank’s leading interest rate: the more the central bank expands its money supply (at given money demand), the lower the leading interest rate becomes. Likewise, a tightening of money supply leads to a rise in the interest rate.
A central bank has many instruments at its disposal to regulate money supply in all its forms, from cash to credit lines. Its control mechanisms are both direct and indirect, but—again—at the heart of its quiver of policy instruments is the one interest rate it has designated as its “lead rate.” This rate reflects the bank’s monetary policy.
The Bank of England, BoE, calls its “lead rate” the “official bank rate.” Since 2007, it has looked as follows:
Source: Bank of England
The big drop in the official bank rate in late 2008 marks the beginning of the response by the BoE to the last fiscal crisis. In 2009, the bank started buying government debt in large amounts; the BoE now owns a total of £895 billion worth of bonds. Some £20 billion of this are corporate bonds; the rest, £875 billion worth of treasury bonds, equals about 36% of the British government’s debt.
Just like the Bank of England, the Federal Reserve expanded its money supply significantly during the last recession:
Source: Federal Reserve
The only noteworthy difference between the BoE and the Fed is the gradual increase in U.S. interest rates in 2016-2019. This was during Janet Yellen’s comparatively prudent chairmanship of the Federal Reserve. Once President Trump replaced her with Jerome Powell, the Fed again abandoned any pretense of monetary conservatism.
Then, of course, came the pandemic of 2020, during which the Fed, like the BoE, returned to an extremely expansionary monetary policy.
The European Central Bank never tightened its money supply after the Great Recession. Figure 3 displays the marginal lending facility, which is the rate that the ECB charges on loans that commercial banks take out from the ECB:
Source: European Central Bank
The liquidity trap
These three figures not only illustrate the exceptional, and internationally coordinated, monetary expansion in the early 2010s, but they also explain why there is no room for monetary expansion today. The key term is an oldie but goodie: the liquidity trap. It means, in short, that the central bank has printed so much money that nobody wants any more of it.
This is not as strange as it sounds. In a sense, money works like electricity. So long as power plants produce about the same amount of electricity we use, the price of electricity is stable. However, if a new power plant adds a major new supply of electricity, the price will drop; if the excess supply is big enough, the power companies will eventually have to give away electricity for free.
If they keep producing excess amounts of electricity, they might even have to pay customers to use it. In other words, the price would be negative.
Money supply under the liquidity trap works much the same way. Once the economy has absorbed all the liquidity it needs, if the central bank keeps printing more money, they will have to give it away. This means lowering the interest rate to zero.
In some cases, rates drop into negative territory; the Danish and Swedish central banks have kept their key interest rates below zero for an extended period of time. The ECB pays negative rates on deposits that commercial banks make when they want to reduce their liquidity balances.
Today, if the Bank of England, the Federal Reserve and the ECB were to expand money supply any further—in order to buy more sovereign debt—they would all have to operate with negative interest rates. The problem is that even with the small, recent interest-rate upticks in Britain and America (Figures 1 and 2), there is not enough room to print the money needed for another government bailout. The extra money supply needed to drop American, British and European interest rates below zero is so small that it would be far from enough to buy all the idle government debt out there.
Once the next fiscal crisis reaches the no-bid point, i.e., where there are no buyers of new or rolled over debt, the amounts needed to pick up that debt will likely be so large that these three central banks combined would not be able to absorb it.
There is only one way to stop the crisis
What happens then? It is very difficult to predict; something like this has not happened before, at least not in modern times. If we go by what standard economic theory tells us, the following scenario is possible (I am purposely not using the term “probable”):
We would have a full-fledged, unmitigated government debt crisis on our hands. Governments would run out of cash, have to panic-raise taxes and panic-cut spending—and do it on short notice, just like in Greece a decade ago, but on a much larger scale. They would postpone payments on outstanding debt and see their credit rating tumble. Commercial banks with large balances of government debt would come under serious solvency stress. The central banks, having exhausted their monetary policy on saving sovereign debt, would be more or less unable to help them.
Again, this is a theoretical, but possible, scenario.
But it is not yet inevitable: there is one way, and one way only, to prevent a runaway debt crisis. It starts with all euro-zone governments putting all other issues aside, including “green energy,” and focusing all their policy efforts on a coordinated, structural plan to bring an end to government borrowing across the euro zone.
It will take major reforms to get this done, including returning some government functions to the private sector. But the very fact of governments working on this plan would be enough to ease the turmoil on the debt markets.
Showing leadership can do wonders in times of crisis.