Despite the unprecedented increase in the European Central Bank’s (ECB) asset purchase program, the spread of Southern European sovereign bonds versus German bonds is rising.
The ECB’s balance sheet has soared to more than 42 percent of the eurozone’s GDP, compared to the Fed’s 27 percent of U.S. GDP. However, at the same time, excess liquidity has ballooned to more than 2.1 trillion euros.
The ECB has been implementing aggressive asset purchases as well as negative rates for years; the reality is that the eurozone economy has remained weak and was close to stagnation already in the fourth quarter of 2019.
The main problem of the eurozone is that most governments have abandoned all structural reforms and bet all the recovery on monetary policy. The excessive government spending, high tax wedge, and burdens to growth remain, while an increasing percentage of growth came from travel and leisure (around 22 percent of gross added value in 2019).
The transmission mechanism of monetary policy is not the problem. Banks are eager to lend, and businesses and families have no problem accessing credit. The problem is that the eurozone leaders and the central bank managers believe that the challenges of the eurozone are demand problems when there was evidence that the output gap was exceedingly small if existent at all.
If there was any evidence, it was that monetary policy in the eurozone didn’t work as an incentive for productive investment and growth, but as a perpetrator of massive imbalances from almost-bankrupt governments.
With the crisis of COVID-19, the eurozone finds itself caught between a rock and a hard place. Its fiscal and monetary policy will likely perpetuate overcapacity in the wrong sectors and excessive government spending, while its tax policy may drive innovation, technology, and productive investments further away.
Now that the European Commission has allowed partial nationalizations of industries, the road to permanent stagnation has been paved. First, governments ignore the risks of the pandemic, then they close the economy by government decision, then they announce tighter controls on foreign investment and capital inflows ... and present themselves as the solution.
The eurozone seems to want to use the COVID-19 crisis to advance its interventionist agenda and its so-called green new deal strategy. The problem is that higher government intervention in the economy will likely lead to more malinvestment, higher unemployment, and lower growth.
The ECB can disguise the risk for a while, but the reality of the mounting debt and tax burden ahead is probably going to end in a debt crisis that could put the entire European Union at risk as governments in the Northern countries receive the bill for the excess spending of some Southern members.
The euro risks losing importance as a global reserve currency, and its utilization in cross-border transactions may fall further, leading to a currency crisis just as the debt burden soars.
Monetizing risk will not eliminate it. We have seen in many countries how massive monetization only disguises risk for some time, but debt crises aren’t prevented because the rising imbalances in fiscal policy generate a constant erosion in confidence and global use of the currency. More importantly, solvency issues aren’t solved with liquidity.
The key for the European Union to remain stable and for the euro to survive is to maintain confidence in the solvency of the nations, not to destroy the purchasing power of the currency.
