What is certain is that another debt crisis will extend and deepen the worst economic downturn since the Great Depression of the 1930s. We might deal with a multi-decade and poorly understood cycle that originated in the 1950s and mixed politics and economics in unknown ways.
People with good memories will remember that, from 2010 to 2012, Europe was stumbled by its first “sovereign debt crisis”. The weakest members of the European Union (Greece, Italy, Portugal, Spain and Ireland) are struggling to avoid a default on their sizable government debt – a task compounded by annual budget deficits.
The crisis was resolved when Greece was allowed to restructure (ie, reduce) its debt and Mario Draghi, who was then head of the European Central Bank (ECB), declared in July 2012 that the ECB would “do anything” to ensure that other countries did not default.
The bargain is clear: countries that are borrowed excessively get debt relief from the ECB, which then effectively guarantees their bonds. In return, borrowing countries cut the deficit so they will not be too dependent on the ECB for credit. For a while, the offer seemed to work. Confidence increases; financial risk falls. But bargaining is fragile. That depends on stable economic growth that disappears with the arrival of the pandemic.
Like the United States, much of Europe has now entered a deep recession. By 2020, the German economy (gross domestic product) will contract by 8 percent, 10 percent for France, 15 percent for Spain, 18 percent for Italy and 15 percent for Greece, reports a new study from Capital Economics, a major forecasting company. Consumer confidence dropped, and the budget deficit widened.
Definition is important. The budget deficit signifies an annual gap between government spending and revenues. Government debt is the cumulative total of all past deficits. Both deficits and debt have grown significantly in Europe, as in the United States. In 2019, the German budget has a surplus of 1 percent of GDP; by 2020, it will experience a deficit of 8 percent of GDP, according to a study in Capital Economics. From 2019 to 2020, the French deficit is projected to increase from 3 percent of GDP to 10 percent. Italy swung to a deficit of 15 percent of GDP, up from 1.6 percent in 2019.
The combination of a shrinking economy and expansion of deficits automatically increases the debt burden. It’s already higher and higher. The Capital Economics report estimates 2020 debts of 73 percent of GDP for Germany, 120 percent for France, 180 percent for Italy and 222 percent for Greece.
Is this sustainable? It is impossible to answer these frequently asked questions directly, because there is no definitive definition of “sustainable.” For most economists, debt is “sustainable” as long as markets – investors, traders – continue to lend voluntarily. This assumes that debts that are due can be “overthrown” into new debt. The answer varies according to country and circumstances.
Based on many factors – low interest rates, records of past loan payments, low inflation – some countries can borrow more than others. Although Germany’s debt ratio is increasing, almost no one thinks it might default. In contrast, Italy and Greece are closer to the brink.
If some sort of financial rescue is not organized, Italy might be forced out of the euro, dragging along with several countries that are deeply indebted. Keep in mind that Italy has third largest economy in the euro zone ( 19 countries which uses the euro as a currency), behind Germany and France.
But organizing a rescue will be difficult, because the amount of money will be very large – think of trillions of dollars – and because recently in power by the German Constitutional Court could prevent Germany from participating in the rescue, economists said Desmond Lachman from the American Enterprise Institute. Without Germany, the largest economy in Europe, other countries can resist.
The stakes here are extremely high. The social and political structure of modern society rests on an economic foundation that enables most people to live a decent life almost all the time. We have taken this for granted, despite the constant grumbling about the perceived shortcomings of the modern economy.
But what do we think is really true? What if we can no longer accept this basic stability? That is actually the problem here. That’s a serious thought.
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