July 18, 2018

The Debt and Dangers of the Eurozone

You may have heard the words ECB, Eurozone, or even “Mario Draghi’ sometime in the past. But who and what are they, and why should Americans care about what’s going on across the pond?

The Eurozone is a monetary union of 19 of the 28 European Union member states that have adopted the euro as their common currency and sole legal tender. The Eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.

The ECB, also referred to as the European Central Bank, is the central bank for the euro and administers the monetary policy of the Eurozone. The objective of the ECB is to maintain price stability within the Eurozone and the bank has the exclusive right to authorize the issuance of euro banknotes. The current head of the ECB is an Italian economist named Mario Draghi, who has been president since 2011.

After the financial crisis of roughly 10 years ago, central banks began a process called QE or Quantitative Easing. QE is the process by which a central bank purchases government securities in order to keep interest rates low and expand the money supply, thus flooding financial institutions with capital with the goal of increasing lending and liquidity.

The European Central Bank has purchased more than 2.5 trillion euro ($2.9 trillion) worth of assets and kept a zero interest rate policy since launching quantitative easing in 2015, in an effort to keep the debt service of Eurozone countries low so that they can increase economic activity and improve their balance sheets. The ECB’s balance sheet is now 40 percent of the Eurozone GDP.

On Thursday, June 14, the ECB said it would reduce its bond purchases in the final three months of the year, and halt purchases all together at the end of December. The ECB cautioned that the plan was subject to incoming data, and that interest rates would remain at present levels until at least through the summer of 2019. Currently the key ECB lending rate is at zero percent. Draghi said the decision to wind down the stimulus program was based on strong economic growth and solid inflation levels.

This decision isn’t unfamiliar. The U.S. Federal Reserve (FED) purchased $4.5 trillion in investments during the years following the financial crisis. The bond buying program ended in 2014 and the FED has since raised interest rates seven times. The FED has been relatively successful in its effort to de-lever its balance sheet.

Europe, however, has more complex issues, including political uncertainty, which has the potential to plague each nation. Just this year, the Italians threatened to leave the EU in its most recent elections, and most feel that the political unrest is far from over. Italy’s debt to GDP ratio is currently at 132 percent. By comparison, at the height of the Greek debt crisis in 2015, its debt-to-GDP ratio was at 178 percent, and shockingly enough, it remains around the same level today.

As it currently stands, seven of the 19 Eurozone members have debt-to-GDP numbers above 95 percent, with many well above 100 percent, including Greece (178%), Italy (132%), Portugal (126%), and Belgium (103.1%), with Spain (98.3%), Cyprus (97.5%), and France (97%) not far behind. For reference, Germany’s debt-to-GDP level is at 64 percent and the United States is at 105 percent.

While these numbers remain tolerable with an expanding global economy, if we start to see economic slowing, especially in Europe, we could see an escalation of problems as these debt-to-GDP numbers rise. In the event of a downturn, at least the United States would be able to implement another version of QE, if necessary. The ECB, however, would be in a much tighter position as it has fewer “tools in the toolbox” because of its current monetary policy and the balance sheets and political ideologies of many of its members.