The euro zone is ripe for another debt crisis. In the following discussion, I will explain why it is likely to expect one, beginning as early as 2023.
This is a bold prediction, and as all economic forecasts, it depends heavily on premises that can easily be upset by reality. Nevertheless, the key variables upon which I build this prediction are clear and concise, and the statistical outlook toward a new recession is reinforced by solid economic theory.
The last debt crisis
Before we look at the reasons to predict a debt crisis for next year, a reminder is in place of what the last crisis looked like.
In the latter half of the last century, recessions grew increasingly shallow, causing some economists to boldly declare recessions a thing of the past. Those predictions were shattered by the Great Recession of 2009-2011, although it is important to recognize that this recession had a different cause than the “regular” recessions that preceded it.
Normally, recessions occur because of higher inflation and rising pessimism in the private sector. Together, these phenomena cause a macroeconomic “cool-off” with declining spending throughout the economy. By contrast, the Great Recession erupted when over-speculated equity markets conspired with unsustainable government debt. The result was a fast and widespread solvency crisis in the financial sector.
I explain in The Rise of Big Government, chapters 6 and 7, that the root cause of the Great Recession was long-term, gradual growth in the size of government. A slow but steady expansion of government over a period of several decades, gradually depressed economic growth rates in both Europe and North America. As a result, governments experienced structural deficits, where tax revenue permanently fell short of welfare-state spending.
In this macroeconomic environment, it did not take much of a blip in regular economic activity to cause the fragile debt situation to unravel. Financial institutions experienced rapidly rising defaults on private debt, but—and this was the key component—they also saw credible debt-solvency problems in sovereign debt.
Credit losses in the higher-risk segment were exacerbated when the risk-free anchor of portfolios was showing signs of unreliability.
To avoid panic in the market for euro-denominated sovereign debt, the European Central Bank began buying treasury securities across the board. This stabilized the debt market, but it also created a serious structural problem, one that is now haunting both the ECB and indebted governments. For reasons we can explain using Austrian-theory economics, the very intervention of the ECB is now threatening the stability that the intervention was supposed to protect.
A structural-deficit problem
At the heart of the problem is the widespread practice among euro-zone governments to run budget deficits. According to Eurostat government-finance data, a majority of the current euro-zone members have run budget deficits in 19 of the past 20 years. This means that most European governments have structural deficits in their finances, i.e., deficits that do not go away over a business cycle.
In 2015-2019, the recovery period after the Great Recession, euro-zone governments together spent €607 billion more than they took in from taxpayers. The only year during that period when a majority of euro-zone countries balanced their consolidated government finances was 2019.
However, even then the numbers were disappointing. Twelve countries ran budget surpluses that year, adding up to a total of €73.8 billion, while seven countries with deficits borrowed a total of €153.5 billion.
If there was any point in time when euro-zone governments should have been awash in budget surpluses, it was 2019. The fact that they weren’t is evidence of a structural-deficit problem—a problem that these governments had already going into the pandemic-related economic shutdown in 2020.
Fortunately, the total deficit for the euro zone in 2020 was only modestly bigger than the total annual deficits during the Great Recession. In 2009 and 2010, euro-zone governments borrowed about 12.2% of their total spending. The deficits in 2020 equaled 13.2% of total government spending.
In other words, euro-zone governments cannot blame their enduring deficit problems on the pandemic. That experience inflicted fiscal problems, but nothing extreme by historic comparison.
Signs of what is to come
As mentioned, it is not easy to predict the next debt crisis. However, an obvious indicator is the cost of debt service, i.e., the interest rate that governments pay in order to keep old creditors and attract new ones. When a crisis erupts, interest rates rise sharply, as they did in the early days of the Great Recession.
The problem, of course, is that governments and investors are not much help in a crisis, when the crisis has already erupted. Fortunately, there are some numbers that can assist us in spotting the crisis on the horizon. Some of those numbers are found in an annual survey from the IESE Business School at the University of Navarra. Under the leadership of Pablo Fernandez, professor of corporate finance, the survey asks market analysts, investors, and other finance and economics professionals for their assessment of what they consider to be the right values of certain market interest rates.
One of the variables they ask about is the so-called risk-free interest rate. This is the rate that the analysts and investors consider to be the minimum return in order to accept an asset as risk-free investment. Technically, no investment is ever risk free; the term is best understood as “the safest possible investment” rather than a strictly risk-free option.
Sovereign debt is traditionally considered risk-free in this sense. Therefore, it is valuable to compare the risk-free interest data from the Fernandez survey with data on budget deficits and yields on government debt across the euro zone.
This comparison sends a clear message: euro-zone governments may soon run out of room to continue to finance their structural deficits.
Not all euro-zone members are at risk, at least not short term. Some countries have made an effort to do away with their deficits; under Angela Merkel, Germany built the strongest public finances in the euro zone. They did it not by reducing the size of their welfare state, but by drawing more blood from German taxpayers. The result was perennial economic stagnation.
Nevertheless, Germany has earned top-tier credit ratings for its public finances. Other countries are not doing nearly as well, with Greece as the most conspicuous example. According to tradingeconomics.com, the Greek government is currently ranked at BB+ by Standard & Poor, Ba3 by Moody’s and BB by Fitch. Other examples:
- Italy is ranked at BBB, Baa3, and BBB, respectively, from the three agencies;
- Portugal is ranked at BBB, Baa2, and BBB; and
- Spain is ranked at A, Baa1, and A-.
Not even France reaches the top tier, scoring at 92% of Germany’s rating.
When government is no longer risk free
In fact, top-tier credit rating is unusual, confirming the point made earlier about structural budget deficits. Since credit rating directly affects the cost of a government’s debt, less-than-perfect ratings across the euro zone suggest that Europe’s heavily indebted welfare states have very little margin when another debt crisis erupts.
To reinforce this point, according to Eurostat:
- The consolidated government sectors in Belgium and Spain have not been able to pay for all spending with current revenue since 2007;
- Last time Finland balanced its consolidated government finances was in 2008;
- Since the start of Eurostat records in 1995, Portugal has had one balanced year, 2019, and Austria has had two, 2018 and 2019;
- France and Italy have been running yearly deficits since at least 1995.
In total, the current 19-member euro zone has run a deficit every year since 1995.
To get an idea of how close we are to a debt crisis, let us compare the risk-free return data from the Fernandez survey with the current return that investors get on ten-year treasury securities. We use the same return throughout the euro zone, treating it as a homogenous market with zero transaction costs between countries.
Immediately, we notice that the risk-free interest rate exceeds what investors get on the ten-year treasury. Starting in 2018, the excess risk-free returns exceeded the ten-year treasury by the following margins:
- Austria, 0.8 percentage points;
- Belgium, 0.4;
- Finland, 0.5;
- France, 0.4;
- Germany, 0.2;
- Greece, 3.6;
- Ireland, 0.4;
- Italy, 1.1;
- Netherlands, 0.5;
- Portugal, 2.0; and
- Spain, 0.9.
When the risk-free rate, as viewed by market analysts and active investors, exceeds the rate you can earn on government debt, it is a sign of a government-created market distortion. This distortion conceals the true credit risk associated with investing in government debt—and is therefore essential in causing a new debt crisis.
According to Austrian-school economic theory, this concealment is the result of excessive monetary expansion. It artificially alters the intertemporal, relative price on capital—interest rates, for short. By printing too much money today, the central bank allocates more liquidity to the present than the free market is willing to absorb.
During “regular” excessive monetary expansion, the private sector misallocates resources due to distorted price signals. Those price signals are eventually corrected by the market, leading to equity-price bubbles in real estate, the stock market, etc. Those bubbles cause crises, but since the signals about those crises come from the free market, they are manageable by the private sector.
In the case of monetization of budget deficits—which is what the euro zone is suffering from—the intertemporal misallocation is driven by government. It is in the very definition of government that it does not allocate resources based on market prices; therefore, when the market mechanisms react to the intertemporal misallocation of resources, government simply presses on with its distorting activities.
As a result, when the bubble bursts, i.e., when government cannot finance its structural deficits anymore, the crisis erupts faster and more violently than when it originates in the private sector.
A new debt crisis in 2023
The best way out, of course, would be to wind down the excessive money printing while the governments of the euro zone implement reforms to reduce their structural deficits. However, to avoid negative macroeconomic consequences, they would have to implement both reforms—monetary tightening and fiscal reforms—in concert and over an extended period of time.
Doing the former but not the latter leaves the deficit-funded welfare states looking increasingly vulnerable in the eyes of the market investors. The prospect of continuing deficits without “buyer support” from the central bank are then combined with the outlook of slower economic growth as interest rates rise.
Slower growth means even more sluggish tax-revenue growth. Which, again, reinforces the structural budget deficits.
This is an outlook that the sovereign-debt market does not appreciate. Can you say ‘debt crisis?’
I fear that this scenario is unavoidable. There is practically no interest in fiscal reforms across Europe, leaving the continent vulnerable to a destructive downward spiral:
- The ECB needs to pull out of the sovereign-debt market in order to cool off inflation and return the risk assessment of government debt to the market; however,
- Monetary contraction raises interest rates, thus slowing down economic activity;
- There are no fiscal reforms to reduce the structural deficits; therefore,
- An emerging recession, driven in part by rising interest rates, erodes tax revenue and exposes deficit-plagued governments to an increasingly skeptical debt market.
How much time does the euro zone have before the next debt crisis?
One key component in any answer to these questions is the balance between the risk-free rates and the yield on government debt. If the former remains stable while the latter rises (as the ECB pulls out of the debt market), the risk for a debt crisis is low. However, if the two start rising simultaneously, the ECB-pullout will destabilize the debt market and in short order lead to a new debt crisis.
Given prevailing fiscal and macroeconomic circumstances, the latter scenario is more likely. Unless there is a decisive change in fiscal policy across the euro zone, the next debt crisis may strike as early as next year.