The eurozone sovereign debt crisis came on the heels of the 2008 financial crisis.
The main focus at all times was Greece. That’s where it started, 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 rather boring) story short, the main struggle during the eurozone crisis was “who bears the blame for Greece’s inability to service its sovereign debt?”
If the eurozone had been the US, not only with shared monetary policy, but also with shared debt issuance and fiscal policy, the problem could easily have been solved. In effect, the Greek debt would have been backed not only by Greek taxpayers, but also by the European Central Bank and the rest of the eurozone taxpayers.
But that’s not the way the eurozone worked (and still doesn’t). Specifically, German taxpayers were unwilling to be on the hook for Greek debts.
So the answer ended up largely being a) Greek bondholders, who saw the value of their debt written down; and b) the Greek population, which endured a severe depression when Greece, under pressure from the single currency, collapsed back to something close to solvency.
How financial contagion nearly shattered the euro
So that’s the main story. But throughout this process there was a much larger underlying concern. That was the fear of “contagion”.
After all, although the eurozone authorities took a long time to reach a conclusion, Greece was small enough that it could leave (or be expelled) from the eurozone without jeopardizing the survival of the single currency.
On the contrary, there were also many other countries with disordered balance sheets. And the markets were quick to realize this.
Investors had spent most of the eurozone’s early years (ie, the 2000s) pushing bond yields across the region closer together. The assumption was that the euro was just the beginning. countries that shared monetary policy eventually it would have to share fiscal policy as well. 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 began to differentiate between the countries of the eurozone. Bond spreads, ie the gap between “safe” German debt and higher-risk countries, burst. In other words, countries with the worst balance sheets saw their cost of borrowing rise.
The “peripheral” countries included, along with Greece, Portugal, Ireland, Spain and Italy. Portugal and Ireland, being relatively small nations, basically submitted and imposed austerity packages similar to those of Greece. In fact, Spain’s finances were not so bad: its main problem was a huge housing bubble.
But Italy – Italy was a problem. A sclerotic economy plus a heavily indebted balance sheet. Also, it was too big to push. It was possible to impose a depression on Greece. Not so Italy, one of the founding member states.
Faced with the risk that some countries, and specifically Italy, would be excluded from borrowing in sovereign debt markets, the eurozone had to take action. That is where Mario Draghi, then head of the European Central Bank (ECB), stepped in. In 2012, Said he’d do “whatever it takes” to save the euro.
In the end, that eventually added up to an open commitment to buy the sovereign debt of the most troubled countries, which in turn would prevent spreads from skyrocketing and allow troubled countries to continue borrowing.
It worked. The contagion stopped. Greece continued to cause spasms of fear, but with risk contained within Greece itself, the broader markets calmed down.
The Italian political struggle rears its head again
For a while, the fundamental problems of the eurozone took a backseat. 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 context. High interest rates were not going to be a problem and central bank intervention was considered standard for most major economies.
Finally, Draghi – the savior 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 flare up again.
First, inflation it’s back. That means interest rates can’t stay where they are. And simply put, if borrowing costs across the board rise and the ECB no longer prints money to channel to countries whose bonds are seen as riskier, then spreads will start to explode again.
Second, Italian political turmoil is rearing its head again. During the years of the Greek crisis, the great nightmare was a left-wing populist party called Five stars. Now the country’s most popular contingent is a right-wing populist movement comprising three different parties, including one led by Silvio Berlusconi.
Now, I am not an expert on Italian politics and since I am almost 40 years old, I am not sure I have enough 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 potential governing coalition have moved away from actively campaigning to leave the eurozone, they all come from Eurosceptic backgrounds.
How will the ECB prevent the eurozone from falling apart this time?
So what’s the plan?
For now the ECB is going to keep raising interest rates. But it also intends to introduce an “anti-fragmentation tool” on Thursday. The purpose of this tool, whatever form it comes in, will be to give the ECB a license to peg eurozone bond yields.
The problem is that they can’t be that open when they reveal it. The lack of general political unity means that the ECB is facing problems very similar to those of the Greek crisis.
At the time, they were unable to bail out Greece because of the idea that it would incentivize “bad” behavior on Greece’s part; in effect, you are penalizing German taxpayers with a more inflationary monetary policy so that Greece doesn’t have to. embark on some much-needed reform (this all 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 from Germany at a minimal premium” because that would seem to run wasteful monetary policy to allow Italy (or any other country that ends up needing it) to reform the duck.
In other words, everything is a bit of a mess 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 also having a political union.
What happens next? I used to think that the eurozone was inevitably doomed in the long run. I’m not so sure about that now. For the euro to collapse, a member state (and one of the big ones) must withdraw. That comes down to politics: you need a political party to make the case and get people to vote for it.
The only country where that seems potentially possible is Germany, as Germany may end up getting fed up with feeling like the baggage carrier for the rest of the eurozone. But even then, I suspect there is too much 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 gradually introduce some kind of common debt instrument (we are achieving this with the coronavirus relief package).
In the meantime, all of this will continue to be a terrible distraction and will most likely contribute to disappointing growth in the region. But individual companies will do just fine.
Given that eurozone stocks are among the most hated in the world right now, I’m tempted to start taking a look. You may want to do the same.