On Europe’s coming fiscal reckoning.
On Europe’s coming fiscal reckoning
A lthough the unrest in France is unlikely to grow into another French Revolution, it could in retrospect prove to be a pivotal moment in triggering the next eurozone debt crisis. French bond yields have risen sharply in the middle of a global bond selloff, and the difference between French and German yields are now greater than at any point since the early 2010s. Other eurozone countries, largely untouched by the crisis 15 years ago, are now also in the danger zone. One thing is clear: Another eurozone debt crisis would not look like the first one.
The eurozone crisis of the early 2010s followed the global financial crisis of 2008. The trigger varied by country: Ireland and Spain saw collapsing housing and credit bubbles, while long-standing fiscal problems and fudged numbers resurfaced in Greece. During the boom years, the common currency delivered an artificially strong euro and unusually cheap borrowing to countries that had previously faced higher interest rates and frequent devaluations of their pre-euro national currencies. When the crisis hit, these now over-indebted countries were unable to set their own interest rates and depreciate their currencies, as they no longer had their own currencies. Rising sovereign yields threatened bank balance sheets (many of which held large amounts of domestic government debt), prompting bank bailouts that further increased public debt and deepened the spiral. Portugal, Spain, Ireland, and especially Greece lost normal market access.
Facing the risk of contagion that could destroy the currency altogether, the European Commission, reinforced by market interventions by the European Central Bank, orchestrated a series of bailouts funded by the vehicles underwritten by eurozone members and the International Monetary Fund. The eurozone was saved, but underneath the surface, structural problems remained.
Though countries such as Ireland staged a strong recovery, in much of continental Europe, growth remained sluggish and deficits remained stubbornly high. The EU’s rule against deficits above 3 percent of GDP continue to be ignored, with France’s deficit running over 5 percent for the past three years. Neighboring Belgium is doing about as poorly, with Italy only slightly better. Less indebted but still vulnerable countries include the likes of Finland and Slovakia. History suggests that investors, if forced to reevaluate one formerly safe haven (e.g., France), will soon take a much closer look at others.
Some American observers have noted that French debt-to-GDP and French ten-year yields are still below American levels. This, however, is cold comfort: America can sustain a higher level of government debt on account of the dollar’s status as the global reserve currency. Also, and while this is far from a get-out-of-jail-free card, technically, the United States cannot be forced to default, since its debt is issued in a currency that it prints. This is not true for France, or any of the other countries that use the euro.
A debt crisis is not by any means a sure thing. What is sure, however, is that such a crisis, were it to happen, would look very different than the one during the early 2010s.
To begin with, a debt crisis would realistically require Thatcherite welfare and tax reforms. Whereas the first eurozone crisis was first and foremost a financial crisis caused by an unsustainable surge in cheap credit overheating peripheral eurozone economies, a new crisis would be a truly economic crisis caused by a decade or more of accumulating structural issues: a loss of competitiveness causing a long slog with little economic growth resulting in little growth in tax revenues, combined with an aging population and an underemployed migrant population. The recent French riots, though not explicitly in response to cuts, have reminded French — and European — politicians of just how dangerous public anger can be, especially coming from the aforementioned immigrant population. France has only implemented modest tightening, and there has already been serious trouble. No doubt this will make many policymakers hesitate to support broader reforms.
The upcoming French presidential election in April next year does not make it easier. The two candidates most likely to make it into the run-off are Jean-Luc Mélenchon, from the far left LFI, and the populist right National Rally’s Marine Le Pen. The former has indicated he would partially default on France’s debt, even openly mocking the idea of “reassuring the markets.” Of the two, Le Pen would be the better alternative, but even she has so far resisted calls to raise the retirement age, even suggesting she may lower it back from 64 to 62, or even down to 60 for certain groups. She does promise other spending cuts, but these may not be enough — even if she’s able to pass them at all.
Second, this crisis would be different because France, in particular, may just be too big to fail. In the aftermath of the eurozone crisis, several measures were implemented to prevent a repeat: The European Stability Mechanism (ESM) is supposed to provide funds for countries in financial turmoil but does not have anywhere close to unlimited resources, and conditions would be attached. Outright Monetary Transactions — the purchase on the secondary market by the ECB of the short-term bonds of a country in trouble — is another backstop, but again this is supposed to have fiscal conditions attached to it. Aiding a country flagrantly violating EU deficit rules would make a mockery of those rules and would encourage others to ignore them, setting the stage for future crises.
An important distinction between the 2010s crisis and what might be coming is that the Greeks and Irish were genuinely concerned that, if they did not yield to the EU’s harsh demands for austerity, they might be kicked out of the club. The French, on the other hand, know that the club does not exist without them in it. Does that mean that France will get off scot-free? Not so fast.
Nobody in Germany requested an encore. During the last crisis, the Alternative für Deutschland party (AfD) — then known as a “professor’s party” with a strong, classically liberal strain — was formed to oppose the bailout of Greece and other troubled member states, arguing that Germany should cut its losses and let them fail. The AfD remains a broadly euroskeptic party, and if another debt crisis occurred, and Germany once again agreed to bail out other members of the eurozone, it just might strike a definitive deathblow to the country’s political mainstream — and even more so if a hypothetical French, Belgian, or Italian bailout didn’t come with the tough conditions imposed on Ireland and Greece last time around. These countries were effectively placed under administration, with years of national budgets having to be approved by an unelected troika of the European Commission, the ECB, and the IMF. France is not a country that likes being pushed around (and it’s not too keen on living within its means, either, having run a budget deficit every year since 1974). French voters might very well prefer default to subjecting themselves to troika rule.
The ECB, having assured investors that the eurozone crisis was a one-time thing, would find its credibility seriously questioned. It could drastically lower interest rates to try to ease the burden on France and other troubled nations, but as always this would come with the risk of higher inflation. With inflation already on a steady upward trend since this summer, and with several countries more worried about inflation than deficits, this balancing act will only get harder.
Making matters worse politically is the fact that the European Union has explicitly endorsed deficit spending for the purpose of rearmament. During the first half of the 2010s, military spending was on the chopping block as European policymakers looked for easy cuts to balance budgets. For geopolitical reasons, that won’t be an option if another debt crisis kicks off, but convincing voters to accept continued rearmament while slashing social welfare will still be a hard sell.
Brussels has also encouraged heavy government spending on decarbonization. Without expensive subsidies, tax credits, and government investment into green sectors, the EU’s already unrealistic climate goals would be completely out of reach. Unfortunately, the sunk cost is too great: Too many industries and too many jobs have been lost, and too much political capital invested in the transition, for Brussels to turn around and say, “Forget net zero, save your economies.” After all, a debt crisis is nothing compared with an uninhabitable planet — which is what Brussels has told Europeans is at stake if they don’t go green.
In 2012 the message from Brussels was a simple “Don’t spend beyond your means,” something voters, however much they hated austerity, fundamentally agreed with. This time, the message would be far more muddled: “Deficit spending is bad, except for in these areas which we in Brussels deem worthy.”
On top of this, the EU is planning to raise membership fees. While the hike, if passed, is not going to be anywhere close to a main deficit driver, it will present an easy political target (“Why is the EU getting more, while our retirees and unemployed receive less?”), further hurting the EU’s credibility with ordinary Europeans.
How it ends is hard to predict. Wealth taxes, which most of Europe already abolished for good reason, would almost certainly stage a comeback as left-wing populism surged. Eurobonds — joint bonds issued by the eurozone — were first discussed during the first eurozone crisis. The proposal was revived during the Covid-19 pandemic, and such bonds would certainly be hotly debated once again.
Supporters of EU centralization will argue that the problem is the EU’s lack of authority to directly intervene in the day-to-day fiscal affairs of its member states, that if Brussels had the power to force countries to raise taxes or reduce spending, national budgets could be balanced. Euroskeptics will, in turn, point to the growth-hampering bureaucracy imposed by the union to make the case that Brussels already has its fingers in too many pies. The skeptics are right, but “less EU” is only part of the Thatcherite package that Europe will need to get out of its low-growth, high-debt slog.
A debt crisis is not inevitable. Though bond yields have risen, no eurozone country has lost market access. If the next French president, likely Marine Le Pen, were to rise to the challenge of taking on France’s entrenched interests and win, this may even provide political cover and embolden other European leaders to follow suit. Otherwise, markets will eventually, like in the 2010s, force Europe to do what its leaders will not. To quote the words of the economist Herb Stein, “If something cannot go on forever, it will stop.”