What a global debt crisis looks like
The global debt overhang is seriously contaminating how governments behave
When you’re highly indebted and constantly battling to avoid default, that obviously influences your behavior. Any medium-term thinking goes out the window, because you’re constantly just trying to make it to tomorrow. The same is true for countries. If you’re at serious risk of default, your incentive is to bend the rules as much as possible in the short term to avoid a debt crisis. That includes bashing your central bank (what economists call fiscal dominance) and financial repression, which means using bank regulations to stuff your financial system with as much government debt as possible.
Yesterday’s unfortunate developments in Brussels add another kind of behavior to the list. There was every reason in the world for the EU to use Russia’s frozen reserves to fund Ukraine. But high-debt countries like Italy and France ended up joining Belgium in its opposition to this and instead pushed for joint EU debt issuance. They did this out of pure self-interest, because this further normalizes joint EU debt issuance and relaxes their budget constraints. The fact that this sends a terrible signal to Russia, China or any other tinpot dictator out there doesn’t matter to them, because these countries are only interested in short-term avoidance of financial turbulence.
The panel of charts above shows the 10-year government bond yield in blue across key G10 economies and the 10y20y forward yield in red. The latter captures what markets price for the 10-year yield in 20 years’ time and is something I back out from 20- and 30-year yields. Long-term yields are rising sharply across many countries, including in Germany and Japan, which in the past used to be safe havens. That puts huge pressure on fiscally distressed countries like Italy and France and incentivizes short-termism. If the EU wants to become a geopolitical player, it can’t allow high-debt countries to dictate foreign policy. This has to stop.
There is no easy way out from all of this. The root problem is that Germany allowed the ECB to cap yields of high-debt sovereigns. If the ECB were prevented from doing that, it would lead to debt crises in Italy and France. That sounds scary, but resulting debt write-downs would fix distorted incentives and end short-termism in European policy making. That needs to start with Northern Europe replacing its representatives at the ECB, but a credible threat of Euro break-up is also needed. High-debt countries have hijacked the Euro and now are also taking EU foreign policy hostage. Germany has to put an end to this dysfunction. It only weakens Europe and emboldens its foes.
Robin, I both agree and disagree here. The way I understand it, there is no clear legal basis for the seizure of Russian assets - which would also complicate a diplomatic solution to the conflict. This is why Euroclear wanted iron-clad guarantees. I think seizure of Russian assets would have been an irresponsible way to get around European excessive debt levels. And it would have been nothing more than a stop-gap measure.
I completely agree with you on your main point: that joint issuance of more debt further undermines fiscal discipline in high-debt countries.
But the bottomline for me is that if Europe wants to play a stronger geopolitcal role, it needs to (1) put its own money at stake (2) become a more cohesive entity, which requires deeper political union; (3) reforms for faster economic growth.
Market discipline through debt crises and write-offs, as you suggest, would certainly be an effective way to encourage fiscal prudence. But an EU disrupted by debt crises in Italy and France would be in no position to run any kind of foreign policy.
Ah…, I didn’t realize I had joined an anti Russia site. I’m out and will leave you to watch EU collapse. I guess betraying the Minks 2 Agreement was a mistake the EU is mow living to regret. Pity it has cost over a million Ukrainian’s their lives.