When divergent economies share a currency without sharing coffers, imbalances invariably arise. German exports and savings, for example, give rise to debts in other countries. A decade ago, such imbalances — together with official mismanagement — resulted in a Greek financial debacle that nearly tore the euro area apart and imposed suffering on millions of people. But instead of addressing the root of the problem by forming a fiscal union, Europe’s leaders reiterated an old pledge: Over time, they would seek to reduce government debts to a safer level.
No such luck. Amid emergency spending to ease the pandemic and blunt the effects of volatile energy prices, debt burdens have headed mainly in the opposite direction. As of 2021, the combined gross debts of euro-area governments stood at 95% of gross domestic product, up from 86% in 2010 and well above the agreed target of 60%.
So is another crisis coming? That will depend on whether investors think European governments can get their debt-to-GDP ratios under control. To some extent, this year’s inflation surge will help, by increasing the denominator. But rising interest rates will make it difficult to keep the numerator from racing ahead.
Consider Italy, with a ratio of 151%. Official projections show its debt burden declining significantly over the next decade. But that’s assuming borrowing costs of only about 2%. If, instead, Italy’s debt rolls over at current interest rates of about 4%, its outlook will be more precarious. Just to keep the debt ratio stable, the government would have to engage in permanent austerity, maintaining an average primary budget surplus (excluding debt payments) of almost 1.5% of GDP — something that, while not unprecedented, would risk popular unrest and impair public investment. Getting the debt down to 60% of GDP, even over two decades, would require sustained primary surpluses larger than any country has ever achieved.
If at some point markets decide that Italy’s debt is unsustainable, officials will have just two options: write off the debt at the expense of private investors, or rescue Italy at the expense of EU taxpayers. Under current conditions, the first would probably trigger a financial crisis, because Italian banks are among the largest holders of their government’s debt. The second is a political non-starter, particularly in relatively well-off countries such as Germany.
Ultimately, only a true risk-sharing union — in which fiscal transfers balance out asymmetric shocks — can ensure the longer-term viability of the euro. In the meantime, Europe must at least create the conditions for relatively orderly sovereign-debt restructurings. To that end, policymakers should accelerate the diversification of banks’ holdings away from the debts of their home governments, require more loss-absorbing capital, and complete the banking-sector reforms — such as harmonizing deposit insurance and streamlining supervisory authority — needed to ensure that failures can be handled with minimal collateral damage.
Beyond that, Europe needs a sovereign bankruptcy mechanism. The aim should be to ensure that, when a government proves unable to pay its debts, losses are imposed on private creditors as quickly and equitably as possible — thus minimizing the involvement of taxpayers and avoiding the kind of serial bailouts that did so much damage in Greece.
As the economist Herbert Stein aptly put it, “If something cannot go on forever, it will stop.” Europe had better be ready.
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The Editors are members of the Bloomberg Opinion editorial board.
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