Eurozone economists who have spent the past week dusting off their debt sustainability models for Italy are feeling a slight sense of deja vu. “All of a sudden everyone must have an opinion on Italian debt yields,” said Gilles Moec, chief economist at French insurer Axa. “Reminds me of 2012.”
Echoing the eurozone debt crisis that erupted 10 years ago, the European Central Bank said on Wednesday it was once again preparing to launch a new bond-buying program to contain a sell-off. sovereign debt that hit more vulnerable countries like Italy. much more difficult than other more stable ones like Germany.
However, there are significant differences between now and then – when the ECB cut interest rates and started buying huge amounts of bonds to tame a debt crisis that threatened to tear the eurozone apart .
Some of these differences make the current situation more concerning, such as the much higher debt levels of many eurozone countries, pushed up by the pandemic and Russia’s invasion of Ukraine.
Italian public debt exceeds 150% of gross domestic product, compared to 127% ten years ago, while Greek debt has increased further, from 162% of GDP in 2012 to 185% last year.
But other factors point in a more positive direction. The first is that European banks are now more a source of strength than weakness. Dozens of undercapitalized lenders had to be bailed out during the 2012 crisis. Since then, most have strengthened their balance sheets, as evidenced by their resilience despite the deep recession caused by the coronavirus pandemic.
An equally important change is the creation by the EU of a common fiscal instrument. An 800 billion euro recovery fund created in 2021 is supporting the countries hardest hit by the pandemic with grants and cheap loans.
The recovery fund meant the ECB was no longer “the only game in town”, as had often been the case in previous periods of crisis, its chairwoman Christine Lagarde said on Wednesday.
Francesco Giavazzi, senior economic adviser to Italian Prime Minister Mario Draghi, cited the new European fund as one of the main reasons he felt investors were too pessimistic about his country’s prospects. That outlook had, he said, been transformed a decade ago – even though the country’s debts were now much higher.
“What really matters to investors is not the level of debt but the trend in the debt-to-GDP ratio,” Giavazzi said. “A small, rapidly growing debt is very worrying; a big [debt-to-GDP ratio] falling is less worrying.
Italy’s €200 billion EU-funded Covid-19 recovery program provides support worth 12.5% of GDP over five years, or 2.5% of GDP in additional demand each year. The regime requires Italy to undertake far-reaching reforms to boost competitiveness and efficiency, which should lift the country’s long-term growth trajectory.
“The plan helps us at least for the next five years,” Giavazzi said. “It will help not to go back to 1% growth.”
Although the war in Ukraine has hit Italy’s economy hard, Giavazzi said output is still expected to grow by around 3% this year, well above its long-term average of below 2%.
In its most recent projections, Rome predicted that its debt-to-GDP ratio would fall to 147% this year, from 150.8% last year and 155% in 2020. Italy’s budget deficit is also expected to fall from 6% . of GDP this year to 3.7% next year, according to the IMF.
“The big difference between now and 10 years ago is that then the debt-to-GDP ratio was going up and the economy was falling,” Giavazzi said. “This time the economy is up and the debt to GDP ratio is dropping like a rock.”
The ECB also has more experience in crisis management. Under Draghi’s leadership, the central bank created a playbook on how to tackle the widening gap in borrowing costs between member states. It has the potential to be quicker and more effective in its response to contain the risk of another bond market panic.
“We are better placed to deal with this crisis from a European and ECB perspective,” said Lucrezia Reichlin, professor of economics at London Business School and former head of research at the central bank. “Many taboos have been broken,” Reichlin added, alluding to the central bank’s difficulties in convincing the political and economic elite in Germany and other northern member states to buy bonds.
A decade later, another big difference is that eurozone inflation is now at a record high of 8.1%.
Inflation makes national debt levels seem more manageable because they are measured against nominal GDP, which tends to be higher when price pressures are high. Governments also generally collect more taxes when prices rise.
However, price pressures are a double-edged sword.
The ECB’s plans, announced on Wednesday, to potentially buy more bonds from weaker eurozone countries would, at first glance, appear to contradict last Thursday’s pledge to tighten borrowing costs by raising rates and by ending previous asset purchase programs.
Difficulties in explaining this policy-mix could weigh on the effectiveness of its strategy to curb price growth, analysts believe.
“Unlike 2014, [the ECB’s] Inflation-fighting benchmarks are now in play,” said Anatoli Annenkov, senior European economist at Societe Generale, adding that eurozone rate setters should “act cautiously.”