Europe's Next Moral Hazard

MUNICH – The euro crisis has passed through six phases so far. It is worth recalling them, because they show how policymakers stumbled along, trying to put out fires without keeping an eye on where their chosen path was leading them. Currently, markets remain calm, but this is only the beginning of a seventh phase of the crisis, during which Europe will become mired in debt. The sequence so far has been as follows:

• The collapse in 2007 of the inflationary credit bubble caused by the euro's introduction.
• The southern eurozone countries' reliance on the printing press to replace private international financing, an option enabled by a dramatic lowering of collateral standards for the refinancing credit provided to banks by the eurozone's national central banks.
• The European Central Bank's purchases of public debt through its Securities Markets Program, aimed at maintaining the value of precisely this collateral.
• Fiscal rescue mechanisms to bail out the stricken countries and the ECB.
• The ECB's promise to buy unlimited amounts of public debt within the framework of the outright monetary transactions (OMT) program, which was intended to encourage further private capital flows to southern Europe, given that the fiscal rescue measures were considered insufficient and politically too restrictive.
• The limiting of creditors' and investors' liability to a mere 8% of the balance-sheet total of banks in the context of Europe's new banking union – a measure aimed at ensuring more private international lending to stricken banks.

The seventh phase of the crisis is one of enhanced moral hazard, stemming from a run-up in debt. With investment risks largely collectivized by the bailout measures instituted by the ECB and the eurozone's member governments, investors are once again accepting low yields, and borrowers are seizing the new opportunities.
To be sure, in 2011 a so-called fiscal compact was agreed in order to avoid precisely this consequence. The compact, signed by all European Union member states except the United Kingdom and the Czech Republic, obliges governments among other things to reduce their (smoothed) debt/GDP ratio annually by one-twentieth of the difference between the actual debt/GDP ratio and the Maastricht limit of 60%. However, the exceptions foreseen in the compact have effectively removed theses constraints.

Had the compact been enforced, Italy would have had to reduce its debt/GDP ratio from 121% in 2011 to 112% in 2014. Instead, Italy's debt ratio has skyrocketed, with a forecast by the European Commission projecting it to reach 134% at the end of this year.
Likewise, Spain's debt ratio should have fallen from 71% to 69%, but will probably increase to 99%. Greece's debt ratio will rise from 170% to 177% (despite a 58-percentage-point debt-relief scheme in 2012), Portugal's will surge from 108% to 127%, and France's will rise from 86% to 96%. But, instead of ruefully admitting their failures, the governments in question are now going on the offensive by rejecting austerity categorically.

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