The coming monetary crisis in Europe

Published in the New Zealand Herald (Auckland), 22 December 2020

As the world approaches the end of this annus horribilis, there is a sense of relief. Not just because 2020 will soon be history but also because the economic disaster could have been so much worse.

Fortunately, many forecasts made in the first half of the year did not come to pass. Yes, both in New Zealand and overseas, we witnessed severe recessions. Yet compared with the gloomy forecasts only half a year ago, economies around the globe have dodged a few bullets.

Considering that many countries spent periods of 2020 in lockdown, saw industries like tourism decimated and trade disrupted, many economic indicators are not too bad.

Especially employment held up remarkably well, even in Covid-ravaged Europe. In Italy, for example, unemployment stands at just under 10 per cent – which sounds bad until you realise this is where it was also at the beginning of the year. In France and Germany, too, unemployment has barely increased over the year, either. In the latter, it is still under 5 per cent. Crisis, what crisis?

Similarly, economic growth is bad but not as catastrophic as feared. After dramatic falls in the first and second quarters, many economies have since rebounded strongly. While not recouping all previous losses, that kept the annual GDP loss in the low single digits in many developed nations. Bad enough but not the economic Armageddon many had feared.

So, did the world economy come out of the Covid-19 troubles largely unscathed? Can we look forward to 2021 and beyond with justified optimism?

If Hans-Werner Sinn is to be believed, we cannot. There are serious risks for the economic future, in particular for Europe. And these risks result directly from those policies that kept the immediate economic damage limited this year.

The name Hans-Werner Sinn may not ring many bells in New Zealand, but Sinn is one of Europe’s top economists.

Aged 72, the former long-time president of Munich’s Ifo research institute is a household name in Germany. That is because, unlike many of his academic peers, Sinn always introduced economic arguments to a wider public – while also maintaining an impressive academic record.

As part of his quest to bring economic policy debates to a broad audience, Sinn established his Christmas lectures. Every year, around mid-December, the University of Munich hosts Sinn in a large auditorium in front of a high-level audience on a big economic policy issue of the year. Over the years, these lectures became social events.

This year, due to Covid, the Christmas lecture took place online only. But still, it was just what one expects from Sinn: a provocative take on the economic situation of Europe.

At the outset, Sinn sketched the background of Europe’s crisis. He reminded his audience that parts of Europe still had not recovered from the Global Financial Crisis when Covid-19 hit their economies in 2020. For example, manufacturing output in Spain, Italy and France was between 10 and 20 per cent lower than in 2007 – before Covid-19.

The pandemic made this economic situation worse – and led to unprecedented fiscal support measures. In all developed nations, not just in Europe, budget deficits skyrocketed. In the US, the 2020 budget deficit will be just over 15 per cent of GDP, while it will be just over 8 per cent for the EU on average.

Combined with the denominator effect of shrinking economies, these budget deficits push up the debt-to-GDP ratio for many economies. Germany will see its ratio increase from 59 to 80 per cent next year. Meanwhile, France will reach 118 per cent, Spain 122 per cent, Italy 159 per cent and Greece even 201 per cent.

Under normal circumstances, one might expect markets to become nervous given such debt ratios. The Maastricht Treaty, which established Europe’s monetary union, once specified a debt-to-GDP ratio of 60 per cent as the maximum tolerable level of debt. At twice that level and more, at the very least one would expect surging yields on European government bonds.

The opposite is the case. Over the course of 2020, the yields on 10-year government bonds have fallen across Europe. They have fallen so much that Spanish government bonds now record a yield lower than US government bonds, while Italy and Greece are now on par with the US as for their 10-year yields.

Now, no serious analyst would contend that the fiscal strength and creditworthiness of Italy, Spain and Greece was on par with that of the US. Yet, these 10-year bond yields suggest this. So what is going on?

The answer, according to Sinn, is the aggression with which the European Central Bank (ECB) pursues its various rescue policies. And there are many.

The ECB has created an alphabet soup of programmes all designed to pump fresh central bank money into markets. So, there is the Pandemic Emergency Purchase Programme (PEPP) – worth €1350 billion ($2329b). And the third instalment of the Targeted Longer-Term Refinancing Operations (TLTRO III) – worth €1308b ($2257b). And another tranche of the Asset Purchase Programme (APP) – worth €120b. Plus, further Pandemic Emergency Longer-Term Refinancing Operations – worth €27b.

Altogether, these measures add up to €2,805b. Still, that was not enough, so just a couple of weeks ago the ECB added yet another €500b of PEPP and an unspecified extra injection in its TLTRO and PELTRO programmes.

Confused? You probably are. But really, it is simple. These measures mean that the ECB is pumping enormous amounts of fresh central bank money into the market.

The result is a massive jump in M0, which measures the sum of central bank money (cash) and bank deposits with the central bank. From a level of under a trillion Euros in 2007, it has reached €4.6 trillion and is on track of reaching up to €7t over the coming two years.

Given this dramatic increase in the money supply, non-economists might expect an immediate increase in consumer prices. But that has not happened yet. And Sinn, borrowing in his argument from John Maynard Keynes, explained why.

Instead of flooding straight into circulation, a large proportion of the extra money is hoarded. It is a classic liquidity trap, except it is not consumers hoarding the cash but commercial banks. They are sitting on the newly created central bank money but not lending it out.

As Sinn argues, that temporary hoarding does not mean that the newly created cash will never find its way into circulation. It will eventually, but it takes time. However, when that moment comes, the reckoning should be dramatic.

Since the ECB’s monetary base has risen so much faster than the economy, there is a built-up potential for a devaluation of the Euro of up to 84 per cent of its current value. Sinn was at pains to say this was not a forecast, and not for the short run, but that it is a clear danger because central bank issuance of money had moved so far ahead of economic activity.

More immediately, there are two threats to the Eurozone’s economy. The ECB’s low interest rates will prevent restructuring industries (a so-called “zombification”), or inflation will pick up, on indeed both (reminiscent of 1970s-style stagflation).

None of these scenarios are pleasant for Europe.

Which brings us back to the starting point. Europe has kept its economy afloat during this extraordinarily challenging year of 2020. The big pandemic crisis did not show up in collapsing GDP figures or spiking unemployment. It was a bad year, but not a catastrophic one.

However, this moderately positive result was bought with staggering central bank interventions. These monetary interventions are such that they themselves could trigger an even bigger economic crisis over the coming years, one characterised by accelerating consumer price inflation, economic stagnation and (something Sinn did not talk about) banking crises.

If this scenario plays out, we may look back at 2020 as the good old times – when a pandemic troubled us but economies still functioned more or less normally.

Over the coming years, we may well move to the opposite: When the pandemic is over but economies have been derailed by past monetary interventions.

It is not an implausible scenario – and one that Hans-Werner Sinn may well dedicate all of his next Christmas lectures to.