‘Spain is not Greece’, the Spanish finance minister swore in 2010. ‘Greece is not Ireland’, her Greek colleague declared a few months later. The Irish finance minister did not allow himself to be told that lightly. “I’m considering getting it printed on T-shirts that Ireland isn’t Greece.”
By designating each other as black sheep, the countries tried to divert attention from their own problems. For Greece, it was the tampering with fiscal statistics, Spain and Ireland had created a real estate bubble. But while the causes differed, the outcome was the same: their government debt was uncomfortably high and their economy was in the doldrums.
Investors’ confidence was hard to find, so that those countries suddenly had to pay sky-high interest rates to borrow money. As a result, they were in danger of going under. The survival of the currency union was hanging by a thread barely twelve years after its inception. Only after European governments and the International Monetary Fund had dug deep into their pockets to give the troubled countries cheap loans did things improve.
Now, more than ten years later, interest rates may rise again. Inflation in the eurozone was 5.1 percent in January, much higher than the European Central Bank’s target of 2 percent. Frankfurt may try to curb price increases by raising key rates. This will also translate into higher costs for governments to borrow.
Greece
Does this threaten a repeat of the euro crisis? Government debt is now even higher than it was then. Where in 2012, five of the current 19 euro countries had borrowed more money than their economies are, now there are seven. Greece leads the way with a debt ratio that, according to Eurostat statistics, is more than 200 percent, despite a debt restructuring that wiped out tens of billions of euros in 2012.
In addition to Greece, Belgium, Spain, France, Italy, Cyprus and Portugal now also belong to the plus hundred percent club. The corona crisis has forced these countries to allocate tens or even hundreds of billions to prop up their economies. Yet despite those mountains of debt, it remains surprisingly calm. No one is saying that bankruptcy is imminent, or that the eurozone is doomed. How is that possible?
The main explanation is that governments now spend much less money on interest payments. Yes, the amount of debt has increased, but because countries have to pay much less interest on it than in the past, the sustainability of government debt has often improved. Italy, for example, spent about 4.3 percent of its gross domestic product on interest payments in 2010, compared to 3.5 percent today. And that while the debt mountain compared to Italian GDP has risen from 119 to 155 percent in that period.
Mario Draghi
Euro countries owe this significant drop in interest charges to a bumblebee, and to an Italian who averted the euro crisis on 26 July 2012. That day, then-ECB president Mario Draghi gave a speech at London’s Lancaster House, a nineteenth-century estate around the corner from Buckingham Palace. Major investors gathered there to talk about the economy and the euro’s chances of survival.
Bumblebees are a ‘mystery of nature’, Draghi surprisingly stated. With their wings they could not move enough air to take off, and yet they do it. He saw it as a metaphor for the euro. The message was that the single currency could survive despite seemingly insurmountable national differences, and the ECB would contribute to that.
Draghi promised in the ‘bumblebee speech’ that Frankfurt was willing to buy unbridled government paper from poor euro countries. ‘Whatever it takes’, he said, and paused. “And believe me, it will be enough.” For example, the Italian put an end to the bankruptcy risk, so that investors again started borrowing money from those countries at reasonable rates.
Funnily enough, the bumblebee mystery that Draghi brought up at the time is not a mystery at all. Physicists have known for decades that the little aerodynamic creature can fly thanks to the viscosity of air. The bumblebee is not as efficient, but has brute strength and works for the greater good. Still a good metaphor of Draghi for the euro.
government bonds
In the years that followed, the ECB also started to buy the debt paper of the strong euro countries, thus also reducing the interest rate at which they have to borrow (for bonds, the price and interest rate move in the opposite direction). Frankfurt wanted to put cash in the hands of investors in those government bonds, in the hope that they would put that money to work in the real economy. Hopefully, if this boosted activity, then still stubbornly low inflation would increase. Nevertheless, inflation remained below the 2% target until the start of the pandemic.
So today, the ECB faces the opposite problem, which is inflation that is too high. Yet the central bank continues to buy tens of billions of euros worth of government bonds every month. ECB executive and president of De Nederlandsche Bank Klaas Knot wants to put an end to this as soon as possible, and thus also clear the way for the first rate hike since 2011. Financial markets are already counting on two rate hikes this year.
So it looks like both the ECB’s policy rate and long-term interest rates will rise. The logical question then is how harmful this will be for public finances in the eurozone. That turns out to be quite alright. Many euro area countries have taken advantage of the historically low interest rates in recent years to limit their future interest charges. They did this by borrowing more than strictly necessary, and at much longer maturities than in the past.
The Netherlands, which, incidentally, just like Germany, Ireland and Malta now has less debt compared to its economy than ten years ago, has also taken part. Ten years ago the average term of the Dutch government debt was three and a half years, in the meantime it has risen to about eight years. Austria even issued a 100-year loan in 2020, on which the Alpine country owes an interest of less than 1 percent.
Lower debt ratio
High inflation – and in its wake higher interest rates – will make new loans more expensive for governments, but there are also benefits for them. This reduces the fair value of the debts they have already issued. The economy that must provide the means to repay those debts grows precisely because of inflation. For example, higher prices lead to higher sales and profits of companies, and therefore higher business taxes. Both developments contribute to a lower debt ratio.
Nothing to worry about then? That is not what Jakob de Haan, professor of economics at the University of Groningen, would like to say. ‘The average maturity of government debt in the eurozone has increased from six to eight years over the past ten years. Nevertheless, the government debt will have to be refinanced in the future, and if interest rates are much higher then the higher interest charges weigh heavily on the budget. In practice this means that many countries will then have to make significant cutbacks.’
Are euro countries looming again on the horizon? There is no clear limit above which bond yields become problematic, says Jack Allen-Reynolds of research firm Capital Economics. “Debt sustainability will also depend on economic growth and fiscal policy, which are difficult to predict.”
Italy
Still, he is making a valiant effort for Italy, which is widely seen as the biggest worry child. De Laars accounts for almost 15 percent of the economy of the eurozone, making it ten times the size of Greece. Like the even bigger brothers Germany and France, the country is too big to fail† “The yield on Italian ten-year bonds (currently 1.9 percent, red.) must rise to 5 percent before we believe the sustainability of government debt is at risk,” Allen-Reynolds said. Because panic can break out in the financial markets if interest rates go up, it would be a good thing that the ECB is ready to buy government paper again and thus limit the interest rate differentials.’
De Haan hopes that it will not come to that and that euro countries will work towards debt reduction. Not only to prevent the ECB from having to help them out again, but above all to be prepared for the next crisis. With a low debt, a government has more clout to act. If there is one country that has proven its worth, it is the Netherlands. After the outbreak of the corona crisis, our economy was one of the first to rise above Jan thanks to the ample fiscal stimulus.’
Leader Greece
No country in the eurozone has such a high public debt to its economy as Greece. To get rid of its creditors, it would have to give up all the wealth it manages to produce for two years. Nevertheless, the sustainability of the Greek debt is not that bad. This is due to the cheap and long-term loans that the country received during and after the euro crisis.
For example, more than half of the 340 million euros debt is in the hands of the European emergency fund, with an average term of 31 years. The average interest the country owes on its debts was 1.5 percent last year. Credit rating agency Fitch expects the Greek debt ratio to have fallen to 185 percent by the end of next year.