Euro Zone: Intermission

Portugal’s Finance Minister and Eurogroup President Mario Centeno gestures during an interview in Lisbon, Portugal, February 28, 2020. (Pedro Nunes/Reuters)
There's no crisis yet, but sooner or later market unease, fueled by the pandemic, will lead to a reckoning.

If there is one thing that those running the euro zone have learned, it is that the inedible can become palatable if left out to fester more thoroughly.

At the end of last week, and after the now traditional bitter arguments, the euro zone’s leadership agreed on a package that could deliver up to €540 billion in funds to bolster the currency union’s economies in the wake of COVID-19.

Essentially, it was made up of what Mário Centeno, the president of the Eurogroup (a steering committee made up of euro-zone finance ministers), described as three “safety nets,” in addition to the sizable interventions already made by the bloc’s “fiscal and monetary authorities,” including the European Central Bank.

These safety nets comprised a fund of up to €100 billion to back up national welfare systems, up to €200 billion in loan finance for smaller companies from the European Investment Bank, and up to €240 billion in “pandemic crisis support” from the ESM (the European Stability Mechanism, the euro zone’s bailout fund). They would, said Centeno, “ensure we grow together, not apart, once the virus is behind us.”

Fine words, although not made more reassuring by their coda:

“These proposals build on our collective financial strength and European solidarity.”


Given that €540 billion will probably not be enough, and that “European solidarity” is understood in very different ways across the currency union, the current pause in the drama will likely be no more than an intermission. The next act will probably be centered on Italy and, perhaps, Spain. If history is any guide, it will end in some kind of surrender by the “Frugal Four” (Germany, Austria, Finland, and the Netherlands), who are — for entirely understandable reasons — holding the line against a proposed next stage: an issuance of pooled euro-zone debt.

Greece’s economic agony over the last decade gives some insights as to how this will play out. The underlying issue, after all, is the same. The euro zone’s more financially responsible members do not want to pick up the tab for those they see as irredeemably spendthrift. Back in 1998, German chancellor Helmut Kohl, keenly aware of the reluctance of his fellow countrymen to replace their trusted deutschmark with a speculative single currency, told the German parliament this:

“According to the treaty rules, the euro community shall not be liable for the commitments of its member states, and there will be no additional financial transfers.”

In The Euro Trap (2014), his entertainingly acerbic account of the single currency’s danse macabre, German economist Hans-Werner Simm notes that Kohl intoned this statement “twice in a row to lend it gravitas.”

Helpful promises tend to evaporate when faced with unhelpful events; this one did not survive the euro-zone crisis a little over ten years later.

In October 2009, the newly elected Greek government revealed that it would run a budget deficit of 12.5 percent of GDP, far higher than euro-zone rules theoretically permitted and far higher than the outgoing government had suggested. Even allowing for the effects of the global financial crisis then underway, it was a startling number.

Greece’s 2009 budget deficit ended up at over 15 percent of GDP, but it took downgrading Greek debt to junk, spiking Greek interest rates, and two austerity programs (and the acceptance of a third) before the euro zone agreed in May 2010 to a bailout of the type that Kohl said could not happen — a bailout that was, as admitted by Christine Lagarde (then France’s finance minister, now the president of the European Central Bank), “against all the rules.”

That said, the conditions attached to the bailout by Greece’s resentful rescue party meant that the country would effectively have to starve itself back into good health. Trapped somewhere in the long run, Keynes’s ghost screamed.

The following year saw further budget-cutting and the “replacement” of Greece’s prime minister by someone more amenable to Brussels. GDP plummeted by over 9 percent. Toward the end of 2011 , an agreement by some of the country’s creditors to write off some of what they were owed was part of a package that became the second Greek bailout, at which point The Economist calculated that the funding Greece had received (or been promised) “from euro-zone lenders and the IMF [would have amounted] to €246 billion by 2016, equivalent to 135% of last year’s GDP.” It was not enough.

Greece’s GDP plunged again in 2012. Two general elections were held, more budget cuts were introduced, and the Greek ten-year government-bond yield shot through 40 percent. The same year, Dutch prime minister Mark Rutte retained his job after an election in which he promised “not one cent more for Greece.”

And yet eventually Rutte (who is still the Dutch prime minister today) caved, and so did all the rest of the “north.” A third Greek bailout was put together in August 2015, but that was not enough either.

In 2018, after Greece was given yet more relief by its creditors, the EU’s commissioner for economic and financial affairs declared that the “Greek crisis” had ended. Among the assumptions that accompanied this happy news was one that Athens would deliver an average annual primary surplus of 2.2 percent until, well, 2060. And if you think that is credible, I have some marbles to sell you.

Greece could be pushed around. It was a small country, with a small economy. It could be ordered to starve itself healthy and it could be made to wait for help. However, facing the possibility that this tiny reprobate might be forced out of the currency union (or even go into default within it), the “north,” fearful of what a demonstration that the euro was not, after all, “irreversible” might mean, blinked. And not just once.

And so, confronted with the prospect that Italy — the bloc’s third-largest economy — might go into default, let alone the danger that it could quit the currency union, the Frugal Four will blink yet again. The Dutch have already conceded that the “pandemic crisis support” from the ESM would be close to unconditional (“the only requirement to access the credit line will be that the country would commit to using these funds to support domestic financing of direct and indirect healthcare, cure and prevention related costs due to the COVID 19”), something that they had previously resisted.

The euro zone has bought itself time with last week’s agreement and, even more so, by what the ECB is doing, and will continue to do, very possibly on a yet greater scale (something that might involve reaching for an unused weapon in its arsenal — “Outright Monetary Transactions,” the purchase of a country’s bonds in the secondary market as a means of bringing yields down).

Nevertheless, none of this is going to make the debt go away. Italy’s debt-to-GDP ratio now stands at around 135 percent, and with GDP falling and debt rising, it is easy to anticipate this ratio rising to 150 percent or beyond. It is debt that Italy, which no longer has its own currency, can neither print nor devalue away, and it is debt that the country — in and out of recession since signing up for the euro — is going to struggle to pay, particularly if Italy’s borrowing costs start — as they may well do — to rise significantly. The notion that Rome would agree to budget-cutting to the extent needed — if that’s even possible — seems fanciful, especially with powerful (and somewhat Euroskeptic) populists in both the coalition government and its opposition.

The idea that the effects of the most likely alternative — a default, but with the country staying within the euro — could safely be kept within Italy’s borders is nonsense. A default would also trigger the collapse of much of the Italian banking system (Italian banks hold alarmingly large amounts of their government’s debt), and the dominoes would tumble across the continent. To start with, according to a Bloomberg analysis from March, European banks outside Italy are holding more than €446 billion of sovereign and private Italian debt, and it’s not as if they are free from other worries at the moment.

And if Italy is driven to go one step further — pull out of the euro altogether — the default will be bigger, and so will its reverberations elsewhere, amplified by capital flight as investors in the remaining euro-zone countries wonder which would be the next to leave.

Under the circumstances, the only question is not whether the Frugal Four will capitulate but when and how. The when will probably be the point at which the spike in Italian interest rates fuels a panic, and the how is more than likely to be “corona bonds.”

For years now, those who want to take the currency union closer to a fiscal union — a move that might make a degree of economic sense but would trash yet more of what remains of national democracy within the euro zone — have pushed for “euro bonds,” an old, respectable term now given a disreputable new meaning. Essentially, these euro bonds would be issued by the euro zone as a whole. Relying on the credit of all euro-zone members, including the Frugal Four, they would carry a far lower interest rate than bonds issued by Italy and could provide a means for the currency union to strengthen its weakest link.

The Frugal Four have opposed such bonds, and still do. They regard them as a major step along the road to a fiscal union in which four countries risk footing some of the bill for their more feckless fellows — forever. In an attempt to make the idea more acceptable to the careful quartet, some of its advocates are relabeling euro bonds as “corona bonds,” a name intended both to tug the heartstrings and to convey the idea that they will be a one-off — a hard task given that the EU’s integration process lacks a reverse gear and has, at best, ineffective brakes.

The pressure on the holdouts continues. On Tuesday, the ECB’s Vitas Vasiliauskas commented that the euro zone’s leadership “should use all ESM instruments but also think about further steps if needed and by that I mean first of all corona bonds.” At around the same time, the Eurogroup’s Centeno was also making clear that these bonds were by no means off the table.

Meanwhile, the spread between yields on Italian and German ten-year bonds is again moving up, a sign of market unease. In absolute terms the difference is not so very high—there’s no crisis yet—and over the next few months markets will do what they will do. The spread will narrow and broaden and broaden and narrow, but the deterioration in Italy’s finances cannot be dodged. Sooner or later there will be a reckoning, made all the worse by being delayed, and corona bonds will be on their way.


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