Europe’s Next Moral Hazard

MUNICH – The euro crisis has passed through six phases so far. It is worth recalling them, because they show how policymakers stumbled along, trying to put out fires without keeping an eye on where their chosen path was leading them. Currently, markets remain calm, but this is only the beginning of a seventh phase of the crisis, during which Europe will become mired in debt. The sequence so far has been as follows:

• The collapse in 2007 of the inflationary credit bubble caused by the euro’s introduction.

• The southern eurozone countries’ reliance on the printing press to replace private international financing, an option enabled by a dramatic lowering of collateral standards for the refinancing credit provided to banks by the eurozone’s national central banks.

• The European Central Bank’s purchases of public debt through its Securities Markets Program, aimed at maintaining the value of precisely this collateral.

• Fiscal rescue mechanisms to bail out the stricken countries and the ECB.

• The ECB’s promise to buy unlimited amounts of public debt within the framework of the outright monetary transactions (OMT) program, which was intended to encourage further private capital flows to southern Europe, given that the fiscal rescue measures were considered insufficient and politically too restrictive.

• The limiting of creditors’ and investors’ liability to a mere 8% of the balance-sheet total of banks in the context of Europe’s new banking union – a measure aimed at ensuring more private international lending to stricken banks.

The seventh phase of the crisis is one of enhanced moral hazard, stemming from a run-up in debt. With investment risks largely collectivized by the bailout measures instituted by the ECB and the eurozone’s member governments, investors are once again accepting low yields, and borrowers are seizing the new opportunities.

To be sure, in 2011 a so-called fiscal compact was agreed in order to avoid precisely this consequence. The compact, signed by all European Union member states except the United Kingdom and the Czech Republic, obliges governments among other things to reduce their (smoothed) debt/GDP ratio annually by one-twentieth of the difference between the actual debt/GDP ratio and the Maastricht limit of 60%. However, the exceptions foreseen in the compact have effectively removed theses constraints.

Had the compact been enforced, Italy would have had to reduce its debt/GDP ratio from 121% in 2011 to 112% in 2014. Instead, Italy’s debt ratio has skyrocketed, with a forecast by the European Commission projecting it to reach 134% at the end of this year.

Likewise, Spain’s debt ratio should have fallen from 71% to 69%, but will probably increase to 99%. Greece’s debt ratio will rise from 170% to 177% (despite a 58-percentage-point debt-relief scheme in 2012), Portugal’s will surge from 108% to 127%, and France’s will rise from 86% to 96%. But, instead of ruefully admitting their failures, the governments in question are now going on the offensive by rejecting austerity categorically.

Italy’s new prime minister, Matteo Renzi, came to power on that platform. Greek Prime Minister Antonis Samaras is trying to counter his leftist rival Alexis Tsipras in the same way. Portugal’s Constitutional Court has thwarted the country’s fiscal-consolidation efforts. And France’s new prime minister, Manuel Valls, is also moving against austerity. Supposedly, everyone just wants more growth; unfortunately, when politicians talk about growth, what they usually mean is that they should be permitted to incur more public debt.

An increase in public debt causes a short-term surge in demand, helping to increase the degree of capacity utilization and keep unemployment in check. However, new debt is nothing but a form of dope, reducing pressure to take painful measures that would improve competitiveness and capacity growth.

This renewed decline in debt discipline reflects the socialization of potential bankruptcy costs among all eurozone countries by way of establishing joint-liability mechanisms. It is this de facto debt mutualization that has prompted creditors to accept lower interest rates, and it is only lower interest rates that have permitted Renzi, Samaras, Valls, and the others to distance themselves from austerity policies.

There is nothing surprising about this: When a decision-maker can claim full credit for a policy’s benefits and collectivize the costs, he will pursue the policy sooner, more quickly, and to a larger extent than he would if he had to bear the costs alone. What is remarkable is how matter-of-factly Europe’s transgressors succeed in cloaking themselves with the mantle of a new social breakthrough.

One only needs to look at the United States to see how dangerous – and indeed unsustainable – the eurozone’s path has become. When one of the US states runs up too much debt, creditors become jittery and austerity measures are introduced to avert the risk of bankruptcy – as has happened in the past few years in California, Illinois, and Minnesota.

But all of that occurs while the debt/GDP ratio is still minimal and clearly below 10%, because creditors know that no one will come to their aid. The Federal Reserve will not buy their government bonds, and the federal authorities will not issue any guarantees.

In Europe, by contrast, easy access to the local printing presses before and after the foundation of the ECB, together with the new fiscal rescue mechanisms, ensure that investors start to become nervous only when debt ratios are 10-20 times as high. As a result, the debt level rises until it spirals out of control.

The critical limit beyond which creditors become anxious has been raised significantly by the bailout architecture put in place over the last two years. This will bring a few years of calm as debt levels climb steadily to that limit. Then the storm will come, battering ordinary citizens, while today’s leaders remain high and dry, drawing pensions.