When divergent economies share a currency without sharing coffers, imbalances invariably arise. German exports and savings, for example, create debts in other countries. A decade ago, such imbalances – coupled with official mismanagement – led to a Greek financial debacle that nearly tore the eurozone apart and imposed suffering on millions of people. But instead of getting to the root of the problem by forming a fiscal union, European leaders reiterated an old pledge: Over time, they would seek to reduce public debt to a safer level.
No chance. Amid emergency spending to mitigate the pandemic and mitigate the effects of energy price volatility, the debt burden has mostly headed in the opposite direction. In 2021, the combined gross debts of eurozone governments amounted to 95% of gross domestic product, up from 86% in 2010 and well above the agreed target of 60%.
So, is another crisis coming? That will depend on whether investors think European governments can control their debt-to-GDP ratio. To some extent, this year’s inflation spurt will help, by increasing the denominator. But rising interest rates will make it difficult to keep the numerator from racing.
Take Italy, with a ratio of 151%. Official projections show that its debt burden will decline significantly over the next decade. But that assumes borrowing costs of only about 2%. If, on the other hand, Italy’s debt rolls over at current interest rates of around 4%, its outlook will be more precarious. Just to keep the debt ratio stable, the government would have to embark on a policy of permanent austerity, maintaining an average primary budget surplus (excluding debt repayment) of nearly 1.5% of GDP – this which, while not unprecedented, would risk provoking popular unrest and harming public opinion. investment. Reducing debt to 60% of GDP, even over two decades, would require larger sustainable primary surpluses than any country has ever achieved.
If at some point the markets decide that Italy’s debt is unsustainable, officials will have only two options: cancel the debt at the expense of private investors or save Italy at the expense of European taxpayers. Under current conditions, the former would likely trigger a financial crisis, as Italian banks are among the biggest holders of their government debt. The second is a political non-starter, especially in relatively well-off countries like Germany.
Ultimately, only a genuine risk-sharing union – in which fiscal transfers compensate for asymmetric shocks – can ensure the long-term viability of the euro. In the meantime, Europe must at least create the conditions for a relatively orderly restructuring of sovereign debt. To this end, policymakers should accelerate the diversification of banks’ holdings away from the debts of their home governments, demand more loss-absorbing capital, and complete banking sector reforms – such as the harmonization of deposit insurance. and streamlining of supervisory authority – necessary to ensure that failures can be dealt with with minimal collateral damage.
Beyond that, Europe needs a sovereign bankruptcy mechanism. The aim should be to ensure that when a government proves unable to pay its debts, losses are imposed on private creditors as quickly and fairly as possible – thus minimizing taxpayer involvement and avoiding the type of series of rescues that have done so much damage in Greece.
As the economist Herbert Stein so aptly said, “if something can’t go on forever, it will stop.” Europe has an interest in being ready.
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The editors are members of the Bloomberg Opinion Editorial Board.
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