There is no indication that the so-called “frugal states” are ready to contemplate debt mutualisation. Permanent damage will flow from the inability to create the necessary institutional framework at the EU level and the failure of the Euro, or even of the EU, is a probable outcome of the current crisis.
The world entered the COVID-19 crisis with a total debt (both public and private)-to-GDP level near record highs. As at the end of the third quarter last year the world debt-to-GDP ratio, according to data provide by the Bank for International Settlements (BIS), reached 239%. This is just below the record of 245% in 3Q 2016 and well above the 211% level recorded at the end of 2007- as we entered the last global recession. Total debt-to-GDP levels are now rising sharply and after the health crisis ends the world will face a debt crisis. The EU, will be plagued not just with record total debt-to-GDP levels but record high disparity between member states total debt-to-GDP levels.
The disparity of total debt levels between member states is an additional problem for the EU
A first look at the data suggests that the EU faces very similar problems to the rest of the world in dealing with its debt. Eurozone total debt-to-GDP, as calculated by the BIS, stood at 267% at 3Q 2019, in line with the Advanced Economies average of 272% of GDP. However, the additional problem that the EU faces is the massive disparity in total debt-to-GDP ratios of its member states.
Within the Eurozone there is only one monetary policy and it must be used to solve each member states debt problems although they are very different in scale. The ECB cannot as a general rule support one country’s sovereign debt market more than the others. A further problem is that key members of the EU are not members of the Eurozone and thus their government bond markets will not benefit from the support of the ECB. Any attempt by these non-Eurozone countries to use their native central banks to support their local government bond markets risks a major exchange rate devaluation triggering a credit crisis for local borrowers who have financed their activities by borrowing in Euros.
In short the EU faces policy challenges due to the divergence in debt-to-GDP ratios of member states and the underdeveloped nature of EU institutions, that are absent for almost all other developed world policy makers dealing with the current record high debt-to-GDP levels. Just how quickly the institutional framework of a nation state can be constructed at the EU level will now determine the extent and duration of damage to be visited on the financial system and economy of the EU. The conclusion of this paper is that permanent damage will flow from the inability to create that necessary institutional framework at the EU level and the failure of the Euro, or even of the EU, is a probable outcome of the current crisis.
In a Crisis, Total Debt to GDP Levels Are the Real Challenge for Policymakers
The history of financial crises shows that debt levels matter to economic outcomes and the nature of policy responses. While current commentary on EU debt levels focuses on the government debt-to-GDP ratio of Italy it would be wise to focus on the disparate total debt-to-GDP ratios within the EU as the real challenge for policy makers. Very high government debt-to-GDP burdens may have negative impacts on future economic growth but, as recent experience in Japan has shown, they can be sustained for a prolonged period without imperiling financial or economic stability. However, as we have learned in credit crisis after credit crisis, defaults by the private sector bring both short-term and long-term damage to the fabric of a financial system and levels of economic activity. As we learned in the last recession, a seemingly sound public balance sheet tells us almost nothing about the financial and economic stability of an EU member state. The experience of Ireland from 2008-2013 serves as a warning that it is total debt-to-GDP that will tell us how well the EU and its member states will weather the current recession. Total debt-to-GDP ratios strongly suggest that EU policy makers face almost insurmountable problems in solving the debt problems while maintaining the integrity of the Euro.
The current focus on government debt-to-GDP levels in the EU misses the scale of the problem. Ireland’s government was overwhelmed by the magnitude of its last financial crisis and forced to take bail-out loans from the IMF and EU institutions and its democratically elected government was subjected to rule by the ‘troika’. Forced to bail out every creditor of its banking system, Ireland’s exemplary government debt-to-GDP ratio of 24% at the peak of the business cycle in December 2007 rose to 132% by 2013. What crushed Ireland was not the level of government debt-to-GDP as the crisis began but the level of government support necessary to bail out a grossly over-geared private sector during the crisis. To focus only on government debt-to-GDP levels in the EU in this recession is to ignore the lesson of recent history that it is excessive levels of leverage in the private sector that threaten financial stability, levels of economic activity and even state bankruptcy.
While in theory the private sector should weather any economic downturn without government support, in practice this does not occur when private sector debt-to-GDP levels are excessive. As it entered the last recession Greece had a government debt-to-GDP ratio of 106% but as the private sector collapsed government debt-to-GDP rose to near 200% and the country’s sovereign debt was eventually re-scheduled. Many EU member states enter the current recession with government debt-to-GDP ratios well above the level with which Greece entered the last recession: Greece (186%), Italy (154%), Portugal (136%), Belgium (124%), France (116%), and Spain (115%). Where such high starting government debt-to-GDP ratios are combined with record high private sector debt-to-GDP levels we have a recipe for financial and economic collapse.
Disparity of total debt-to-GDP levels between France and Germany
The real problem for the EU is that France enters the current recession with the second highest total debt-to-GDP ratio in the world apart from the offshore banking centres! Germany enters the current recession with one of the lowest total debt-to-GDP levels in the world. While the world asks whether Germany is prepared to bail-out Italy and Spain, the question will soon become: Is Germany big enough to bail out France?
When the Euro was launched, France’s total-debt to GDP ratio was 195%, and Germany’s was 183% – a gap of just 12% of GDP. As of 3Q 2019 the gap between German and French total-debt-to-GDP had risen to 150%! The gap in government debt-to-GDP between France and Germany has risen from 7%, at the end of 1998, to 47% of GDP by 3Q 2019. The gap in private debt-to-GDP between France and Germany has risen from 5%, at the end of 1998, to 103% of GDP by 3Q 2019. In the non-financial corporate sector, the change in the debt-to-GDP ratio has been from a gap of 40% of GDP, at the end of 1998, to 96% of GDP by the end of 3Q 2019.
For several decades, analysis of both governments and corporations, has been blighted by too much of a focus on flows rather that stocks. The much-heralded convergence within the EU has been focused on measures of flow such as GDP growth and annual fiscal deficits and has almost entirely ignored the rapidly growing divergence in debt-to-GDP levels particularly the divergence between its two most important members – France and Germany.
As it becomes clear, yet again, that key private sector liabilities are actually public sector liabilities, these massive divergences of debt-to-GDP within the EU will make it almost impossible for the member states to agree to anything but a token mutualisation of fiscal responsibility. Which private sector, through higher taxes, pays for the financial irresponsibility of other countries private sectors is a deeply political and divisive issue. It is one unlikely to lead to the greater concentration of power in Brussels that remains the essential element in creating a functioning and enduring single currency.
France is not the only EU country with high total debt to GDP ratios.
When we lift the focus from government debt-to-GDP ratios to total debt-to-GDP ratios we see that France is not the EU’s only problem child albeit that it is its biggest. For some countries in Europe, who have been the centers for massive tax avoidance by other members’ corporations, it is difficult to tell what portion of their debt is actually supported by local GDP or is supported by corporate revenues from elsewhere. In such countries multi-national corporations raise debt and transfer expenses and profits from other jurisdictions to reduce their tax liabilities. The total debt-to-GDP levels for these EU tax havens far surpasses the levels of France (281%) and Italy (265%): Belgium (336%), Luxembourg (415%), Netherlands (322%), and Ireland (305%).
There are also EU member states where tax avoidance has played no role in boosting debt levels and yet their total debt-to-GDP levels are incredibly high: Portugal (300%), Greece (294%), Sweden (293%), Spain (267%), Denmark (264%) and Finland (244%). In any mutualisation of debt, Germany – with a total debt-to-GDP ratio of just 183% – puts its balance sheet on the line to bail out excessive debt levels right across the EU. It is doubtful whether the political will for such a bail out exists in Germany, but it may even be, given the scale of the public bail out of EU private sectors, that it does not even have the capacity!
In the short-term the current health crisis has triggered the utilization of the limited debt mutualisation that is currently possible through the European Stability Mechanism. It is also likely that the terms and conditions on which member states receive transfers through such mutualized debt will remain very materially weakened. However this health crisis brings with it an economic crisis on a grand scale and will require, according to nine EU members including both France and Italy, a mutualisation of debt that is highly unlikely to be politically acceptable given its scale and the nature of what it will finance.
It is an economic crisis on a grand scale as it is triggering government intervention to support the private sector on a scale unparalleled in peace time. It is the need to pour public capital into the private sector, either directly through loans and equity, or indirectly through directed government orders that will ultimately stop the mutualisation of debt within the EU and threaten the existence of the Euro
Could debt mutualisation be used to support uncompetitive national corporations?
There will be a limit to the extent of EU debt mutualisation as key member states realise just how much of the money so raised will flow into the coffers of other nation states’ corporations. Across the world, governments are currently in the business of establishing which businesses taxpayers’ money can be used to save and which must be left to go to the wall. Putting such life and death decisions for corporations in the hands of politicians, seeking funding and re-election, is fraught with dangers. This becomes even more perilous if the funding to bail out one country’s corporations comes, at least partially, from the tax burden placed on another country’s corporations. One country’s politicians may provide public finance on easy terms while another country may enforce punitive terms to provide fresh capital to failed businesses. For instance, a highly uncompetitive business in France could receive EU funding on very favourable terms to allow it to out compete a German company requiring no such bail-out. Yet all the money potentially so inequitably distributed will be subject to repayment by all the governments of the EU with a particularly heavy burden for payments of principal and interest falling upon Germany.
Without some form of centralised control and centralised agreement on the terms and conditions of bail outs, the doling out of money raised by the EU to local businesses is a recipe for a massive political and social bust up between the member states. Even within nation states there is little justice or equity in allocating public funds to bail out the mistakes of the private sector. Establishing a just and equitable distribution of mutually raised funds to bail out private sectors across borders will be politically almost impossible. It is ultimately a purpose to which mutually raised funds will not be put. When that political barrier to further mutualisation is reached, then the reality will dawn that the Euro will never have the centralised functions that are necessary to create a viable single currency. The only solution to this barrier to mutualisation would be the rapid agreement by member states to the centralised control of the flow of mutually raised funds for each of their necessary bailouts.
Which governments would submit themselves to such centralised control of their spending and their choices over which native corporations live or die? Italy has made it very clear that it will not do so. If no such centralised control is possible how will the taxpayers of the north accept the bail out of the corporations of the south, at the whim and bias of local politicians, when they are ultimately responsible for the payment of principal and interest on the debt raised for this purpose?
The conclusion must be that while the mutualisation of debt may progress to fight the health crisis it cannot progress to the grand ‘Marshall Plan’, financed at the EU level, that key member states now demand to fund their economic recovery. At some stage in the mutualisation process German taxpayers, where government, households and corporations have avoided excessive leverage, will baulk at bailing out the government, households and corporations of member states who made less prudent choices.
The point at which that further mutualisation becomes impossible is when it is realized that France, one of the world’s most highly geared countries, is simply too big to save. At that stage it will be up to the central bank of each member state to adapt the necessary policies to fund economic recovery and pursue policies aimed ultimately at reducing record high debt-to-GDP levels. When such a shift in policy becomes necessary the Euro will then exist, if at all, in name only.
Professor Russell Napier has been an adviser on asset allocation to institutional investors for twenty-five years and is author of Anatomy of The Bear: Lessons from Wall Street’s four Great Bottoms.
This article was first published on Briefings for Britain, and is republished with permission. You may not use, copy, distribute, publish, syndicate, sub-license and transmit the whole or any part of such material in any manner and in any format and/or media without the permission of the original publishers.
Picture of Bruno Le Maire, French Finance Minister, by European People’s Party – EPP Summit, Brussels; December 2014, CC BY 2.0, Link.
