Covid’s threat to European financial stability

Dr Bryce Wilkinson
4 November, 2020

The resurgence of Covid-19 in Europe is ending hopes of a quick recovery from a-sharp “V-shaped” recession. Will it be a U-shaped recession, an L-shaped recession? Or will it trigger something much worse, a major slump or depression?

A Covid-induced collapse of the eurosystem could be such a trigger. The associated uncertainties, disruption and adjustments would be a threat to financial stability. Concerns about Brexit would seem minor in comparison.

France and Germany have just announced new national lockdowns. England is on much the same path. Belgium, Ireland, Greece and Austria have all tightened their restrictions as well. US phone-maker Apple’s Covid-related mobility data shows Europeans are travelling less.

Germany is the one to watch here. It is the largest economy in the fragile eurozone and is very export dependent. The struggling, heavily-indebted weaker member countries look to it for financial support. A new round of lockdowns will knock Germany’s capacity to export and provide financial support. Many firms will struggle.

So far, Berlin has worked to stave off corporate insolvencies. Those interventions are due to expire in December. To an extent, such efforts risk only delaying recovery by futilely propping up zombie firms. The new lockdown raises those stakes.

Germany’s central bank, the Bundesbank, expects 6000 corporate insolvencies in the first quarter next year. Assuming the eurozone survives, insolvencies in 2021 should not reach the levels of the 2008-09 GFC, but they will surely surpass the 19,000 annual insolvencies in each of 2018 and 2019.

A deeper recession is now official. Last week, the European Central Bank said its own economic forecasts for the December quarter are now too optimistic. Economic activity “was losing momentum more rapidly than expected.”

Ambrose Evans-Pritchard at the UK Daily Telegraph opined that the eurozone faces a double-dip recession unless it gets “double-barrelled” fiscal and monetary support. The ECB has said extra assistance would be announced in December after reviewing “all instruments” at its disposal.

The new central bank mantra of being ready to open the floodgates to apparently unlimited credit creation feels like a train wreck in the making. Ever-cheaper money must become destabilising if it isn’t stopped. But when it ends, does the train crash?

Evans-Pritchard is concerned these “ritual” announcements to “do what it takes” are about as effective as a rain dance. The ECB has already injected about €3 trillion of liquidity through bond purchases. It is hard to see this tactic driving yields down much further and other measures are dubious at best.

The usual plea in dire situations like this is to rely on the competitive economies (like Germany) more heavily to subsidise other members. But there’s only so far they can stretch the rubber band of goodwill and capability before it breaks – economically and politically.

The need for the ECB to channel resources to struggling sectors comes from the fiscal independence of member countries. But it is not the best solution to the problem. Monetary policy works best as an across-the-board instrument. Trying to target it in a discriminatory way perpetuates structural issues and misallocates resources. A poor remedy for the actual problem will also fail to cure it.

Economists say monetary policy is best directed at achieving price stability, with some discussion about intermediate targets. Using it to reduce unemployment is more problematic. It could fail and compromise stability along the way.

A major current worry is that loose monetary conditions are fuelling asset price inflation. Investors in government bonds are paying high prices in the expectation that central banks will soon pay even more for them. Investors in sharemarkets are paying high prices because they expect governments to inject trillions of dollars into the financial system.

And yet, some economists want governments to double up on the debt and credit creation. Some argue that borrowing costs have never been cheaper and high public debt is serviceable as long as national income grows faster than the debt burden. That will please only the imprudent, the myopic and those without a sense of history.

European leaders and central banks need little encouragement. UK interest rates are low because the Bank of England has created credit on a massive scale. Investors are paying over-the-top prices for UK government bonds because they expect the Bank of England will soon pay even more for them.

None of this can last. What’s happening in Europe is another stress test for investor belief in whether monetary aid is a solution or a sticking plaster.

If they stop believing, then interest rates will rise and asset prices will fall, particularly among the weakest EU economies. A lot of money would be lost and many people would be angry.

The various European governments would become desperate as they watch their revenues shrink and borrowing costs rise. In serious cases borrowing costs can absorb 20 percent of tax revenues. Exchange rates would realign in a painful way if the eurozone broke up.

Governments might try to directly control interest rates and foreign exchange. Advisors will tell their governments not to cut spending or raise taxes. But so-called “fiscal austerity” might be the only option left short of national debt default.

The best fix is for faster sustainable national income growth and greater labour market flexibility. That would reduce unemployment and raise government revenue.

Meanwhile, Europe has the debt and credit creation tiger by the tail. Its problems are unenviable – even aside from Covid – and the risks of financial crisis are real.

New Zealand has much to be thankful for. But we are not an island when it comes to global financial crises. And we are on the same debt and credit creation path.

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