Is the eurozone heading for another crisis?

Christine Lagarde – the ECB is to unveil an “anti-fragmentation tool”

(Image credit: © Dursun Aydemir/Anadolu Agency via Getty Images)

By John Stepek

published 19 July 2022

in Features

“Whatever it takes” is no longer enough to shield the euro

The eurozone sovereign debt crisis came hot on the heels of the 2008 financial crisis.

The main focus throughout was Greece. That’s where it kicked off, when an incoming Greek government revealed that the national balance sheet was in a much worse condition than anyone had thought.

To cut a long (and pretty boring) story short, the headline struggle during the eurozone crisis was “who carries the can for Greece’s inability to repay its sovereign debt?”

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If the eurozone had been the US – with not just shared monetary policy, but also shared debt issuance and fiscal policy – the problem could have been solved easily. In effect, Greek debt would have been backed not just by Greek taxpayers, but also by the European Central Bank and the rest of the eurozone’s taxpayers.

But that’s not the way the eurozone worked (and still doesn’t). German taxpayers specifically were not keen to be on the hook for Greek debts.

So the answer largely ended up being a) Greek bondholders, who saw the value of their debt written down; and b) the Greek population, who endured a severe depression as Greece – under the duress of the single currency – deflated its way back to something approaching solvency.

How financial contagion nearly shattered the euro

So that’s the headline story. But during this whole process there was a much bigger underlying concern. That was the fear of “contagion”.

At the end of the day – although it took the eurozone authorities a long time to come to the conclusion – Greece was sufficiently small that it could have left (or been ejected from) the eurozone, without jeopardising the survival of the single currency.

By contrast, there were plenty of other countries with messy balance sheets too. And markets weren’t slow to pick up on this.

Investors had spent most of the early years of the eurozone (ie, the 2000s) driving bond yields closer across the region. The assumption was that the euro was just the start. Countries that shared monetary policy would eventually have to share fiscal policy too. So a Greek bond was just as good as a German bond, because they were all backed by the same thing.

That assumption was shattered by the Greek debt crisis. As a result, investors started to differentiate between eurozone countries. Bond “spreads” – that is, the gap between “safe” German debt and higher-risk countries – blew out. In other words, countries with the worst balance sheets saw their cost of borrowing rise.

The “peripheral” countries included, alongside Greece, Portugal, Ireland, Spain and Italy. Portugal and Ireland, being relatively small nations, basically knuckled under and imposed similar sorts of austerity packages to Greece. Spain’s finances were in fact not that bad - its main problem was a massive housing bubble.

But Italy – Italy was a problem. A sclerotic economy plus a heavily-indebted balance sheet. Moreover, it was too big to push around. Imposing a depression on Greece was possible. Not so Italy, one of the founding member states.

Faced with the risk that some countries, and Italy specifically, would in effect be locked out of borrowing in sovereign debt markets, the eurozone had to take action. That’s where Mario Draghi, then head of the European Central Bank (ECB) came in. In 2012, he said he would do “whatever it takes” to save the euro.

In the end, that eventually added up to an open-ended commitment to buy the sovereign debt of the most troubled countries, which would in turn keep spreads from exploding, and allow troubled countries to continue borrowing.

It worked. Contagion was halted. Greece continued to cause the odd spasm of fear, but with the risk contained to Greece itself, wider markets calmed down.

Italian political strife is rearing its head again

For a while, the fundamental problems of the eurozone faded into the background. The Brexit vote almost certainly helped – it’s always good for cohesion to have something to triangulate against.

But more important was the ongoing deflationary backdrop. High interest rates were not going to be a problem and central bank intervention was regarded as standard for most major economies.

Finally, Draghi – the saviour of the eurozone – went from being the head of the ECB to being the Italian prime minister.

But now everything is changing. And suddenly, existential fears about the eurozone are erupting again.

Firstly, inflation is back. That means interest rates can’t stay where they are. And put simply, if borrowing costs generally are going up, and the ECB is no longer printing money to funnel into the countries whose bonds are viewed as most risky, then spreads are going to start blowing out again.

Secondly, Italian political turmoil is raising its head again. During the Greek crisis years, the big bugbear was a left-wing populist party called Five Star. Now the most popular contingent in the country is a right-wing populist movement comprising three different parties, including one led by Silvio Berlusconi.

Now I’m no expert on Italian politics and given that I’m in my late 40s, I’m not sure there are sufficient years left to become one. But the upshot is that Draghi may end up resigning and that could result in elections, and while the various members of any prospective governing coalition have backed away from actively campaigning to leave the eurozone, they all have eurosceptic backgrounds.

How will the ECB stop the eurozone from cracking up this time?

So what’s the plan?

For now the ECB is going to keep raising interest rates. But it also intends to unveil an “anti-fragmentation tool” on Thursday. The purpose of this tool – whatever shape it arrives in–- will be to give the ECB a licence to tie eurozone bond yields together.

The problem is, they can’t be as overt as that when they unveil it. The lack of overall political unity means that the ECB faces very similar problems to during the Greek crisis.

Back then, they couldn’t bail Greece out because of the idea that it would incentivise “bad” behaviour on the part of Greece – in effect, you’re penalising German taxpayers with more inflationary monetary policy so that Greece doesn’t have to embark on much-needed reform (all of this depends on your point of view, to be clear, it’s not black and white – but that’s the nature of the argument).

So now they can’t say: “we want Italy to be able to borrow at a minimal premium to Germany” because that then looks like running profligate monetary policy in order to allow Italy (or any other country that ends up needing it) to duck reform.

In other words, it’s all a bit messy in the eurozone again, and we’re back here for the same reason as before: you can’t have a fully functional monetary union without having a political union too.

What happens next? I used to think the eurozone was inevitably doomed long-term. I’m not so sure about that now. For the euro to crack up, a member state (and one of the big ones) needs to pull out. That boils down to politics – you need a political party to argue the case, and people to vote for it.

The only country where that seems potentially possible is Germany, in that Germany may end up getting fed up with feeling like the bag carrier for the rest of the eurozone. But even then, I suspect that there is too much of a sense of obligation for that to happen.

So in the long run, I think the path of least resistance is to lean heavily on the ECB for support during crises; and to gradually introduce some form of common debt instrument (we’re getting there with the coronavirus relief package).

In the meantime, all of this stuff will continue to be a horrendous distraction and more than likely contribute to disappointing growth in the region. But individual companies will do fine.

Given that eurozone equities are among the most-hated in the world right now, I’m tempted to start having a look. You might want to do the same.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.