ECB, EU on alert for possible new debt crisis

Written by Tassos Dassopoulos

The European economy is gradually entering a dangerous path that could lead to a new debt crisis for the “big” countries of the Eurozone after the recent European elections and the political problem they created mainly in France and to a lesser extent in Germany.

The impetus for developments will be the implementation of the revised fiscal compact, which has already given a red flag on the deficit in France, Italy, Belgium, Slovakia, Malta and Poland, as well as the country currently holding the rotating presidency of the European Union, Hungary. This excessive deficit operation may be “hypothetical”, since the new quadrennial budget plans for each country are imminent, but it has a common denominator: the assessment of Member States by the single criterion of the increase in net primary spending, which will be agreed in advance and cannot be changed. This system has been proposed by the Commission, but it is inspired by Germany (and is somewhat reminiscent of the constitutional brake that applies to the country). This is because it separates the expenditure track from the income track.

This becomes clear in Greece because from 2021 onwards, the government can proceed with tax exemptions and reductions, due to overperformance of revenues. This system ends in 2024, with 2.1 billion measures implemented since the beginning of the year and within the limit set by the Commission from 2023 to increase spending by 2.6%. But for 2025, as it has become known, there will be a “cutoff” of an increase in spending of about 3%, i.e. about 3.15 billion euros.

Even if revenues outperform, as expected, the spending limit will not be exceeded. As is well known, Greece will have a deficit of 0.8% of GDP in 2025, while debt is expected to decline from 153% of GDP at the end of 2024 to 145% in 2025. However, the outperformance of revenues will become a “cushion” for the coming years. The performance of other southern countries, such as Spain and Portugal, will be similar, giving the general picture that southern Europe has become balanced, and now the problem lies with the large economies of the euro area.

Adult problem

However, the problem that France and Italy will face will create a new bad scenario for the eurozone and the entire European Union. The finances of the second and third largest economies of the European Union. will get worse in 2025, leading to higher deficits and debts, without new measures of course. In the meantime, both will have marginal growth in today’s data.

The problem will start from the moment Brussels demands adjustments to the two countries’ budgets, which will amount to austerity measures. This is because serious cuts are needed for these countries’ deficits to fall below 3% of GDP and for their debts to reverse course and move downward.

All this while the new French government, which is expected to be formed with the participation of the Popular Front, has been elected with an additional spending program of 95 billion euros, while in Italy we have a government that will last for the last three years and has strongly resisted any kind of cuts.

The role of the European Central Bank

The European Central Bank, through its president Christine Lagarde, has declared its readiness to intervene in any difficult situation. The matter, as in any similar case, will depend on the duration and severity of the phenomenon.

However, French, Italian and other eurozone bonds, which will be under attack from the markets, could force it to reverse the restrictive monetary policy it started two years ago to contain inflation. In fact, it has also prepared the so-called transmission protection instrument (TPI), which, despite being institutionalized since 2022 due to the sharp rise in eurozone debt during the coronavirus pandemic, has never been activated in practice.

The question is whether the Governing Council will accept a further increase in its portfolio to the 5.3 trillion euros that the ECB has raised from the markets through APP and EPP from 2024 to 2023, and above all, what message will be received by the markets, which may react to a new major intervention.

Another question is what will happen to the still high euro interest rates, at 4%, if at the same time the European Central Bank, in an attempt to save the bonds of certain countries, floods the markets with liquidity again.

Damage to debt-ridden countries

However, if the crisis persists in France and neighboring Italy in the eurozone, which is expecting a fragile recovery—it is a question of whether it will reach 1% this year—the problem will become fatally systemic. Greece will be hit from two sides. The first is economic growth, which will de facto slow from the 2.5% target, and the second is the cost of borrowing.

This means that the Greek debt situation will probably improve from year to year, having fallen by more than 55% of GDP since 2020, the year of the pandemic, until the end of 2024. However, Greece remains the most indebted country in the eurozone, which is why, in each such case, the amount of debt is “paid” by increasing yields not only on bonds with a maturity of more than one year, but also on interest-bearing treasury bonds, with which part of the government’s needs are financed. Therefore, a new crisis in the eurozone would also have its costs in Greece, even though it is now one of the most typical countries in the eurozone.