The euro has withstood a lot of criticism – and is still a debt burden

Brussels, Berlin Skepticism prevailed when the euro was introduced as cash at the turn of the year 2002. Germany struggled with the “Teuro” because the prices were at least felt higher than in the D-Mark era. US economists predicted the early failure of the common currency. Investors also looked at the euro with suspicion.

20 years later, even the critics have to admit: The common currency did not go under. It has survived the financial crisis, the euro crisis – and in all likelihood it will also survive the economic slump as a result of the pandemic.

But the rescue policy and also the reform sluggishness of many member states during the numerous crises has driven the national debt to alarming heights since the outbreak of the financial crisis: The total debt of the euro member states is 13 trillion euros.

Particularly worrying: France and Italy account for almost 45 percent of the debt with 2.8 and 2.7 trillion euros respectively. Big debt, big challenges.

The currency area will therefore sooner or later face a financial problem. Because the real challenges – the climate-friendly conversion of the industry and the demographic problems – are still to come.

Ifo boss Clemens Fuest sees the sharp rise in debt as a “major risk”. Above all because “because Europe needs leeway in future crises”. The International Monetary Fund (IMF) sees a “difficult balancing act” for the governments. The increase in debt increases the “susceptibility to crises”.

The new head of the Kiel Institute for the World Economy (IfW) even goes one step further: The German government must make it clear that “there is no alternative to the euro for Germany,” says Stefan Kooths. Otherwise he fears significant price increases and fundamental damage to the European economy.

In fact, inflation is already back. In Germany, the price increase was 5.2 percent in November, and 4.9 percent in the euro zone. And historical experience teaches us that rising inflation rates will sooner or later be followed by higher capital market rates.

At this point at the latest, the financial markets will raise the question of debt sustainability. Rescue with side effects: the role of the ECB Even during the euro crisis, financial investors attacked Greece and other southern states because of their unsustainable debt.

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The former ECB boss Mario Draghi then promised to “do everything in the power of the central bank to save the euro. In fact, the central bank has left no stone unturned to hold the euro zone together.

This rescue policy can be read off from the central bank’s total assets. In total, it rose from 830 billion euros in the year the euro was founded to currently 8,500 billion euros. Not least because of the sharp rise in debt, the ECB never got out of crisis mode.

Since the outbreak of the euro crisis, the European central bank has been buying up government bonds from the countries, some of which it now holds 40 percent of all debt securities. This has led to the fact that even highly indebted euro countries can borrow money very cheaply, from which some economists draw the conclusion that debt is basically no longer a problem in these times.

The trauma of the euro crisis is having an impact

But interest rates are also so low because the ECB is buying up bonds on such a large scale. The corona crisis showed how tense the situation is despite low interest rates. The EU reconstruction fund arose less from a solidarity idea than from deep concern, especially in Berlin, that the crisis could tear Italy financially into the abyss – and possibly the euro with it.

The big question now is where, despite the already high debt levels, the money for necessary investments for digitization and the fight against climate change should come from.

In order to stop the emission of greenhouse gases by the middle of the century, the annual investments have to increase from 683 billion to more than 1000 billion euros, the EU Commission calculates.

Most economists agree that saving would be poison for the economy, at least now. But will the markets keep their nerve if highly indebted countries like Italy continue to accumulate deficits? These are the crucial questions that the finance ministers of the EU countries will be faced with in the coming year. The trauma of the euro crisis is having an impact, old wounds threaten to reopen.

Softening of the Maastricht criteria

The EU Commission has long since adjusted to the new debt situation. Since what cannot be, it is planning a reform of the Maastricht criteria with the active participation of the two highly indebted countries France and Italy. The main issue is the debt limit of 60 percent of gross domestic product (GDP).

The old rules no longer fit in with the times given that the euro area’s debt level is now 100 percent. EU currency commissioner Paolo Gentiloni therefore wants to regulate debt reduction for each individual member state in the future. “We cannot lump all countries together. The differences in the debt ratios are too high for that, ”said the Italian to the“ Frankfurter Allgemeine Zeitung ”.

The demands are extremely explosive. For the EU, but also for the German traffic light coalition. On the one hand, there are the Greens, who are openly in favor of reform. “If we want to hold Europe together, we have to shape the rules based on solidarity and adapted to economic realities,” explains Rasmus Andresen, spokesman for the German Greens in the European Parliament.

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On the other side is the FDP. Although party leader Christian Lindner does not want to pursue a fundamental European opposition from the Federal Ministry of Finance, he knows that a softening of the debt limits will be difficult to convey to his party. Countries like Austria, Denmark, Sweden and the Netherlands also strictly oppose such a reform.

And the Chancellor? Olaf Scholz leaves everything open. When asked about a reform of the EU debt rules, he replied with the sentence rehearsed during the election campaign: The Stability and Growth Pact had proven its flexibility during the pandemic. Scholz is of course aware that the debate cannot simply be stalled.

“There is a lot to be said for getting away from the 60 percent limit as a one-size-fits-all rule,” says Armin Steinbach, professor at the HEC University of Economics in Paris and a former official in the Federal Ministry of Finance. “We should look at debt sustainability, not just its amount. That means taking into account factors such as the interest burden and growth prospects. “

In contrast, Michael Hüther, director of the Institute for the German Economy (IW), says that debt sustainability, as measured by the debt ratio, remains decisive for the euro zone.

And the front runner is Greece with 207 percent, followed by large countries such as Italy with 156, Portugal with 135, Spain with 122, ahead of France with 114 percent. The answer to this could “not be an arbitrary weakening of the Maastricht criteria”. He believes that a change to the so-called 1/20 rule is necessary, according to which the 60 percent limit must be reached again within 20 years. “This is unrealistic,” said Hüther.

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Ifo boss Fuest says a balance is needed between more leeway and more financial discipline. “Above all, it is important to prevent individual countries from shifting the burden of their debts onto the community, for example by needing help in the next crisis because they go into it with high debts,” said Fuest.

IfW boss Kooths sees it similarly. Above all, he sees Germany as having an obligation to free the ECB from its role as financier of the euro countries. “If heavily indebted countries know that a country like Germany doesn’t watch forever that the central bank is supposed to play the cleanup, it would discipline it from a fiscal point of view,” explains Kooths.

There is not much time to come to a common position. In the summer, the EU Commission wants to present a reform proposal.

A debate has long since begun in Brussels as to whether the Corona reconstruction fund should become a permanent pillar for financially weak euro countries. Many well-known EU politicians as well as ECB boss Christine Lagarde are pushing for it.

Economists, however, are skeptical: Hüther is calling for the current EU reconstruction fund to be used to promote the reduction of the debt ratio through reforms and more growth. “France remains a challenge in terms of reform policy, because not much has remained even of Macron’s plans,” said Hüther. France must be stabilized by the EU by using the EU fund.

The inflation risk for the euro zone

All of the debt plans are risky, especially against the backdrop of the changing inflationary panorama. According to the ECB, the high inflation rates are only a short-term, temporary phenomenon.

But there are increasing voices of those who believe that prices could rise faster for a longer period of time. And historical experience shows that, sooner or later, rising inflation rates will also go hand in hand with rising capital market rates.

In such a scenario, the ECB will not be able to oppose it, like the US Federal Reserve, the Fed, initiating the exit from the ultra-expansionary monetary policy. The conditions on which the euro countries take out loans could worsen.

It is true that rising prices initially reduce the burden of debt – money loses value, which makes it easier to repay loans. And in fact, it takes a few years for higher interest rates to show through on the debt burden because states borrow over a longer period of time.

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Nonetheless, rising capital market interest rates in the long term represent the greatest risk to public finances. Sooner or later, governments will have to cut spending. Growth would suffer, financing conditions would deteriorate further – a vicious circle.

“Interest rate hikes are particularly problematic when real interest rates rise, that is, rising interest costs are not offset by rising public revenues and a devaluation of outstanding debts,” warns Fuest.

His suggestion: A change in the debt rule should be combined with the introduction of a “capital adequacy requirement for banks that hold large amounts of government bonds from their own country”.

That would lead to “more diversification of the bank portfolios and facilitate the restructuring of government bonds in the event of over-indebtedness”. However, the southern euro countries are blocking this. They fear that taking on new debt would suddenly become more expensive.

Hope despite difficult starting position

The outlook for the European currency area is by no means all gloomy after 20 years. “The experiences with the economic dynamism in 2021 against the background of reform efforts like in Italy, but also in Greece are encouraging”, says Hüther.

And as big as the problems are, at least the Europeans are better prepared for new crises than they were before the euro crisis. With the euro rescue package and the European bank resolution mechanism, an established rescue architecture now exists, and the ECB has also proven itself as the guardian of the euro in all the crises.

However, if the euro is to have two quieter decades ahead of it after the turbulent first 20 years, in which its existence is not constantly being called into question, the euro states must do what, with a few exceptions, they have never done in the past two decades: Reduce debts once in a while.

More: France’s Finance Minister Le Maire on EU debt rules: “The 60 percent are obsolete”

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