Europe's Debt Crisis Could Pick Up Again This Year

European countries have not been able to break the connection between state finances and banks, which was one of the main reasons for the national debt crisis. Investors may refocus on this vulnerable spot next year, global ratings agency S&P Global Ratings said.

Despite the implementation of general supervision and the creation of separation mechanisms that should eradicate such threats, banks and public finances in many countries continue to be highly connected. Nor is that expected to change anytime soon, the company said in a report released on Thursday.

“Problems in the banking sector can also damage national finances as waves, and vice versa – we call this the doom loop of public finances,” S&P analysts Nicolas Charnay, Cihan Duran and Karim Kroll wrote. “At the same time, when economic growth is weak, the fiscal and monetary policy differences of countries can bring the negative relationship between banks and governments under the sharp attention of the markets again.”

Their study discusses how the relationship in question could lead to difficult situations in 2024, as several factors indicate that the risk of recession is high. They also pointed out that in 2020 the Maastricht criteria were temporarily abandoned, but in 2024 they want to re-establish the rules. This could exacerbate differences between countries.

Investor Confidence May Disappear Again

Analysts suggest that a situation similar to the previous debt crisis may arise, where the markets lose confidence in the monetary policy of a country, which in turn starts to damage the banks of that country.

“Disagreements between European Union member states regarding fiscal policy are getting bigger and bigger, which can give more momentum to greater fluctuations in the markets and, in the worst case, result in a loss of investor confidence,” the analysts wrote. As an example, they cited the 2022 pension fund crisis in Great Britain, of which one of the instigators was Prime Minister Liz Truss.

The second scenario is one where the decision of the member states to tighten their belts in finance begins to damage the banks due to the resulting economic problems. The third danger point is the overly strict monetary policy of central banks. Recently, Fabio Panetta, head of the Italian Central Bank, also warned people against this.

Although banks have reduced their exposure to countries and their budgets (mainly through government bonds), this is likely to be a cyclical phenomenon and will not last, analysts said. They stated that the supply of government bonds is increasing and that the current rules and measures encourage banks to invest in them.

The European Union Wants To Reintroduce Rules That Most Countries do not Comply With

The member states of the European Union are currently negotiating what fiscal rules should be set for governments and how quickly countries should start reducing their debt burdens.

According to the previously valid Maastricht criteria, the budget deficit of a euro area member state could not exceed 3% of GDP, and the state’s debt burden could not exceed 60% of GDP. Most of the countries have violated these rules – and the total debt burden of the euro area countries is 90% of the currency union’s GDP. Whereas these rules were violated even before the 2020 corona crisis, when they were put on hold.

At the same time, the European Union wants to make crazy investments to carry out the green revolution. A McKinsey study reveals that 28 trillion euros must be invested until 2050 to meet the so-called climate goals. This means annual investments that reach 3-4% of the GDP of the European Union.

At the moment, it is not known exactly where this money will come from. The situation is complicated by the fact that many countries are also increasing their defense spending.

At the same time, Germany has announced that countries should reduce their debt burden by at least 1% of GDP each year. The European Commission and France are of the opinion that any debt reduction (by even less than 1%) over the next four years is a good solution. However, the four-year transition period can be extended to seven years, if the government invests in priority areas in the EU’s opinion, such as the green revolution.

European Countries are Groaning Under a Record Debt Burden

The debt burdens of European countries have come down slightly compared to the peaks of 2020-21, but mainly due to inflation, because it has artificially inflated the GDP of the countries against which the debt burden is measured.

Greece continued to be the country with the highest debt burden in the second quarter of 2023 (166.5%). It was followed by Italy (142.4%), France (111.9%), Spain (111.2%), Portugal (110.1%) and Belgium (106%). The debt burden in the European Union was the lowest in Estonia – 18.5%.

Inflation has somewhat reduced debt burdens over the course of a few years, because the debts taken are fixed in euros, but inflation inflates the gross domestic product of countries. The gross domestic product shows the value of products and services in euros that reached final consumption in the country during a certain period of time. As prices have risen, then it inflates nominal GDP and thus also reduces the relative debt burden.

A Comment by Tavex Analysts:

“Higher interest rates will bring the unresolved underlying issues of last year’s European debt crisis to the fore again next year. 

The current debt-based monetary system is structured in such a way that debt burdens must grow over the long term. To date, debt burdens have grown to such a high level that there are no good options to resolve the situation. The talk of tightening the belt is unrealistic, because more and more interest is paid on the debt load. This would mean a very serious drop in the standard of living in Europe, because in this case, more and more of the money of countries, companies and people would go to repaying debts. In my opinion, debt reduction goals can only be achieved through inflation or a drastic drop in living standards. The path of inflation means that the European Central Bank has to create new money, which causes a rise in prices, but also inflates the nominal value of national economies in euros. This, in turn, means that the debt-to-economy ratio falls, which makes it easier to repay.

When it dawns on state leaders and central bankers that tightening the belt also means very difficult times in the economy, they decide to drop interest rates sharply again. Presumably, money will be printed again. However, the French and the citizens of Southern European countries ultimately do not agree with tightening the belt, which puts pressure on the countries to choose the path of inflation. This is one of the factors that will contribute to the arrival of the second wave of inflation, which will probably be much larger than the quietly ending inflation wave of 2021-2023.”