Monday, November 1, 2010

Is There Really a European Sovereign Debt Crisis?

The past few months have seen a flurry of articles warning that the next stage of the financial crisis will be a flight from sovereign debt, specifically in the European periphery. Even people who don't believe in confidence fairies when it comes to the US or the UK accept the conventional wisdom that financing the deficit of the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) is a problem -- that there is simply no way to convince the public to hold the amount of debt these countries will have to issue in the absence of austerity. For these countries, it's sadly conceded, in the absence of the option of devaluation the hard exigencies of the bond market leaves them no choice but slash spending and force down wages.

But is it true? Here are the relevant debts and deficits, in billions of euros (not percent of GDP, for reasons that will be clear in a moment.)

General Government Debt and Net Borrowing

2010 2009 2008
Greece Net debt 259 230 199

Net borrowing 19 32 18
Ireland Net debt 86 58 41

Net borrowing 28 23 13
Italy Net debt 1542 1473 1395

Net borrowing 80 80 42
Portugal Net debt 135 121 105

Net borrowing 12 16 5
Spain Net debt 1051 1054 1088

Net borrowing 97 118 44
PIIGS Net debt 3073 2936 2828

Net borrowing 236 269 122

Source: IMF, World Economic Outlook

(General government here includes all levels of government; "net" means that intra-government borrowing is excluded.)

As we can see, deficits approximately doubled in the PIIGS countries between 2008 and 2009, and stabilized in 2010. But how big are these deficits? Are they, for example, big compared with the balance sheet of the European Central Bank?

ECB Assets (billions of euros)

4th week of October of...







Euro-area bank loans







Euro-area securities







Total assets







Source: ECB, Weekly Financial Statements

In passing, it's interesting how different the balance sheet of the ECB looks from the Fed's especially before the crisis. While the asset side of the Fed's balance sheet, at least until three years ago, consists almost entirely of treasury bills, the ECB has more lending to banks, much more foreign exchange reserves, much more gold (about 10 percent of its pre-crisis assets!) and relatively little in the way of securities. For present purposes, though, two points stand out. First, the ECB increased its security holdings by E320 billion over the past two years, or E160 billion a year. This is equal to two-thirds of the total annual borrowing of the PIIGS countries. So in principle the ECB would only have to increase its current rate of securities purchases by 50 percent to meet the entire borrowing needs of the five threatened countries. Second, looking now at stocks rather than flows, the ECB increased its balance sheet about about 1 trillion euros between 2005 and 2008. Another similar increase would allow the ECB to purchase one-third of the entire outstanding debt of the PIIGS countries. Interestingly, this is very similar to the increase in the Fed's balance sheet over the same period. More to the point, it's well within the range that has been suggested as an appropriate size for a second round of quantitative easing (QE2).

Now, I'm not suggesting that the ECB should actually finance all new borrowing by ECB countries facing crises, or try to monetize a substantial portion of their existing debt. For one thing, there's no need to; presumably even modest additional purchases would be enough to convince private actors to hold the debt at a reasonable price, if the ECB made it clear it stood ready to do more. I'm just saying that the frequently-heard argument that the governments of Southern Europe are "too big to save" isn't obviously true. It seems more likely that any European QE2 -- quantitative easing in its current use, remember, just means big central bank purchases of long-dated government debt -- that had appreciable macroeconomic effects would be more than enough to solve the sovereign debt problem as well.

Of course people (or their equivalents in the world of respectable business opinion) get very upset when you suggest that a government debt problem can be solved by just monetizing it. Oh, they say, but that's inflationary. Maybe; but in the current context that's an argument for it, rather than against it. And given that the 2005-2008 expansion of the ECB balance sheet didn't produce any noticeable upward pressure on prices, it;s hard to see why another comparable one would. OK, they say, but what about the incentives? Why should governments ever show fiscal discipline if they know the ECB will just bail them out when they get in trouble? And there's the heart of the matter, I think. It's not that Greece, Spain, and the rest need tough austerity because they can't be bailed out; rather, they won't be bailed out in order to force them to implement austerity.

The metaphor you sometimes see for the European sovereign debt situation is of mountain climbers roped together above a cliff. If one falls, it goes, the others can hold him up. But if they don't act quickly and more fall, then the ones still holding on may be pulled down themselves if they don't cut their companions loose. Maybe a more apt analogy would be that the climbers up top have a powerful winch, securely bolted to the rock; they could pull up the danglers just by turning a crank. But they wonder, wouldn't it be better to leave them hanging, to teach them a lesson?

EDIT: The counterargument is that, while there is no technical problem with the ECB guaranteeing the financing of budget gaps in peripheral Europe, this would exacerbate the anti-democratic character of Euorpean institutions by giving the ECB a quasi-fiscal role. This is a trickier question.


  1. ECB alone is keeping Ireland alive with its liquidity program. Spain and Portugal will share Ireland's fate in a near future. How much of ECB's credibility is left then?

    European debt crisis

  2. Well, the argument I am making is that the expansion of the ECB's balance sheet over the past few years dwarfs anything that would be required to support the market for Spain's public debt, let alone Portugal's and Ireland's, and the potential costs (higher inflation or inflation expectations, an uncontrolled decline of the euro, etc.) that one might have expected are nowhere to be seen. So it's hard to see the tangible danger to the ECB's credibility -- unless, of course, austerity is a goal in itself.

  3. (It's possible I'm conversing with a spambot here. But whatever, no harm in clarifying the post.)