What is the ‘torment cycle’ in the eurozone?

TA hose large enough to remember the 2010-12 euro crisis will have a slight sense of déjà vu on June 15, when the European Central Bank (ECB) called an emergency meeting. On the agenda were the widening spreads, or spreads, in the interest rates of eurozone countries’ government bonds compared to benchmark German bonds. These spreads decreased after the European Central Bank promised to intervene with a program that had not yet been designed. But fears of the Euro 2.0 crisis remain. High on the list of economists’ concerns is the so-called ‘doom loop’ between different parts of the economy. What is the death ring, and why are people so concerned about it?

A country runs the risk of collapse when a shock to one part of its economic system is amplified by its effect on another. In rich countries, central banks must have the ability to stop this vicious cycle by standing behind government debt, stabilizing financial markets, or lowering interest rates to support the economy. But in the eurozone, the European Central Bank can only do this to some extent for individual countries.

The most dangerous link is between banks and governments. After the financial crisis in 2008, banks in heavily indebted eurozone countries began buying large amounts of government debt. Between 2009 and 2015 in Spain, for example, banks increased their holdings of Spanish government bonds from about 2% of total assets to more than 9%. National banks have an advantage over international competitors because politics has made it difficult for governments to default on their payments. But this created a two-way link: not only were governments exposed to risks from their banks; Banks faced an immediate threat if the country was hit.

Breaking the feedback loop has been a major goal of reforms in the eurozone. In 2012 the “Banking Union” was born. Hereby, since late 2014, the European Central Bank has been responsible for supervising the largest banks across the currency bloc. They are now in better shape, so governments are less exposed to the risks of banks. But the link has been weakened rather than removed. In particular, banks in Italy hold large amounts of Italian government paper and are therefore vulnerable to the Italian bond shock.

The second part of the torment cycle is between banks and the economy. Europe is a largely bank-based economy. A banking system that impairs its ability to lend to businesses and households is hurting the broader economy, and a weaker economy in turn causes more businesses and households to default on their loans or mortgages, again hurting banks. Between 2008 and 2015, the share of non-performing loans due to Italian banks increased from about 6% of total loans to 18%.

The third part of the episode links sovereignty and the economy. A government under fiscal stress may have to cut spending or raise taxes when the economy is weak. This, in turn, can exacerbate financial problems.

The eurozone is in less danger of doomsday than it was ten years ago, thanks to reforms in the banking system, the European Central Bank’s commitment to preserving the euro and some embryonic financial integration. But the danger has not disappeared. And reforms to the eurozone’s structure that would reduce risks further faltered – in part because the European Central Bank intervened boldly in 2012, relieving pressure on governments to make tough decisions. With the European Central Bank stepping in once again, the prospects for deep reform in the Eurozone look increasingly remote.

Leave a Comment