EURO CRISIS 2.0 June 2020 - Douglas J. Elliott - Oliver Wyman
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EURO CRISIS 2.0 June 2020 Douglas J. Elliott
Euro crisis 2.0
There is a serious risk of a sequel to the Euro Crisis that ran from roughly
2010 to 2015. The likelihood of such a crisis is hotly debated and depends
on one’s views of a number of factors that are summarized in this paper.
My own base case continues to be for some version of Euro Crisis 2.0 over
the next two years, but recent positive developments may cause me to
lower that probability somewhat below 50 percent.
This version of the crisis could begin at any time, since the underlying
weaknesses exist and there are many potential triggers. The crisis would
likely proceed more quickly than last time, given what has been learned from
the first crisis and the economic and political tools that have been created.
That said, it could still be a multi-year process.
What would this mean? Economic and financial conditions in Europe would be
substantially more volatile and financial institutions could face major challenges,
including the potential for a full-blown financial crisis in one or more countries.
The effects would be smaller beyond Europe’s borders, but the economies
of trading partners would be impacted, as would financial exposures of foreign
institutions to Europe. There might also be opportunities for some of the big
US banks to acquire European institutions that have been off-limits in normal
times, not to mention opportunities to pick up market share through organic
growth in Europe.
© Oliver Wyman 2Euro crisis 2.0
THE BIG PICTURE
Views about a potential new Euro Crisis depend primarily on how one weighs the positives and
negatives of the Eurozone’s situation. I’ve broken the key points down into reasons for concern,
reasons for hope, and the crucial questions that could tip the balance.
My own base case is that we have a Euro Crisis 2.0 that lasts for a couple of years, but that Europe
once again works through it without a breakup of the Eurozone or other extreme outcomes.
That would not make the crisis costless, though. Crises can pack a lot of pain into two years
and there are likely to be at least mini-financial crises in one or more Eurozone member states
if we do have the sovereign debt crisis.
There is a plausible scenario that is more optimistic, in which actions of the European Central Bank
(ECB), national governments, and European institutions are sufficient to weather the storm
without a real crisis. I may even elevate this to be my base case, if recent positive developments
continue. Sadly, there is also a plausible scenario in which the Eurozone is badly shaken and one
or more member states restructure their sovereign debt, with associated financial crises in the
most affected nations.
These scenarios are somewhat correlated with pandemic scenarios, since worse health outcomes
that lead to a deeper and longer recession would increase the pressures considerably. However,
there are many European-specific factors that are not directly driven by the pandemic.
Reasons for concern
• Sovereign debt levels in many Eurozone countries exceed the levels of 2010
• Political environment is worse now
• Coronavirus Recession is worse than the Great Recession
• Corporate sector is overloaded with debt in many countries
Reasons for hope
• EU and Eurozone have more economic and financial tools now, and are using them
• There is considerable potential for further Eurozone integration in response to the crisis
• Interest rates are lower than in 2010
• Nature of the recession’s cause garners sympathy for weaker Eurozone countries
Crucial questions
• How bad will the Coronavirus Recession be in Europe?
• How far will moves towards fiscal federalism go?
• How effectively has the Banking Union reduced the feedback loops between banks
and sovereigns?
• How seriously will markets, and other stakeholders, take the threat of exits from the Euro?
• What will be the impact of the German Constitutional Court’s rulings on ECB’s powers?
© Oliver Wyman 3Euro crisis 2.0
REASONS FOR CONCERN
Sovereign debt levels in many Eurozone countries exceed the levels of 2010. Italy has received
the most attention. As an economy that is “Too Big to Fail,” the country has been hit horribly
by COVID-19, and which will face many challenges in pulling out of the hole it is in. At the
beginning of the Euro Crisis, Italy’s debt-to-GDP ratio was about 115 percent, versus 85 percent
for the Eurozone as a whole. A decade later, Italy started 2020 at roughly 135 percent, while
the Eurozone as a whole was only up to 86 percent. All of these figures will be considerably
higher as a result of the pandemic.
Political environment is worse now. In the first years of the Euro Crisis, analysts and politicians
were very concerned that voters would revolt if national leaders crossed various “red lines” that
they or their predecessors had laid down. Yet, time after time, leaders were forced to cross those
lines yet managed to do so without dramatic short-term political consequences. Arguably, the
accumulation of these choices helped set off the populist/nationalist voter uprisings that came
later, but leaders did find that they had the room to maneuver and that they needed to find
compromises to hold the Eurozone together.
The picture in 2020 is quite different in much of the Eurozone. Populist and nationalist parties
are much more powerful than in 2010 and even entered the government in Italy before falling
out again. National leaders in the Eurozone are all watching carefully to try to avoid losing power
to these populist parties and therefore will feel more constrained.
The Coronavirus Recession is worse than the Great Recession. The Global Financial Crisis and
the ensuing Great Recession helped set up the first Euro Crisis by sharply worsening national
budget deficits. The Coronavirus Recession is similarly harming government finances, only the
increase in deficits is much sharper this time around. We do not yet know the full course of
the recession, but the cumulative impact is very likely to be worse than in the Great Recession.
My own view is that the most likely economic scenarios are worse than the market consensus,
mostly because of the high risk of recurrences of the pandemic in many regions that could
trigger strong containment measures again. The lockdowns would likely be milder and for
shorter periods than was the case in the first wave, but most forecasts give too little weight
to the risk of future waves.
The corporate sector is overloaded with debt in many countries. Partially as a result of monetary
policies that made credit cheap and widely available, businesses around the globe took on
additional debt since 2010. Europe is no exception.
This worsens the risk of a new Euro Crisis in several ways. First, it increases the drag on national
economies, including by worsening unemployment. Second, it further harms budget deficits
by reducing tax revenues and forcing larger rescue packages. Third, it creates non-performing
loans that drag on the banking system, slowing the economy further and potentially requiring
government-funded capital injections for the banks.
© Oliver Wyman 4Euro crisis 2.0
REASONS FOR HOPE
EU and Eurozone have more economic and financial tools now, and are using them. European
institutions are in much better position in 2020 than they were in 2010 in terms of the policy
tools available to them to fight against the disintegration of the Eurozone. The ECB has a
range of tools that were created to fight the previous Euro Crisis and it is using these tools
very actively now. The central bank has much more ability to buy government bonds of troubled
Eurozone countries than was the case in 2010, although there are still political and, potentially,
legal constraints. The ECB has also entered into a number of very large long-term refinancing
operations (LTROs) for banks over the years. Collateral requirements to borrow from Eurozone
central banks have also been eased considerably. Further, the European Stability Mechanism
(ESM) was put in place during the Euro Crisis and is available to supply large amounts of funding
for sovereigns, albeit with strings attached that can create political difficulties in accessing those
funds. Various elements of the Banking Union have also been put into place, as discussed later.
There is considerable potential for further European integration in response to the crisis.
In addition to policy tools that already exist, a number of methods for furthering European
integration are being considered. Most importantly, President Emmanuel Macron of France
and Chancellor Angela Merkel of Germany recently proposed a 500 billion euro Recovery Fund
to be financed by borrowing in the EU’s name, to be repaid out of the EU’s own budget in
future years. The European Commission took this even further and on May 27, 2020 proposed
a 750 billion euro Recovery Fund, with a mix of grants and loans. This proposal is likely to be
modified to some extent by the European Council (representing national governments) and
the European Parliament, but I expect the broad outlines to be approved.
Any step of this nature would be a big move towards fiscal integration of the EU, since member
states have not previously allowed debt financing of the EU budget. This would be an even
bigger step if the EU is given the right to collect taxes to finance the debt, as opposed to relying
on future contributions to the budget from the member states. The European Commission
has proposed several taxes, including on digital activity.
Such a recovery fund, or other steps towards fiscal integration, would widen the ability of the
EU to support member states that are particularly hard hit by the pandemic or, in the future,
by other crises. This would spread the pain over a wider base and make it easier for national
governments to cope with crises.
Interest rates are lower than in 2010. Debt levels are higher, but the cost of servicing the debt
is lower, especially interest payments. This means that higher debt levels do not have as bad an
impact on annual budget deficits. However, that may not help a great deal if the issue becomes
one of investor confidence, which is likely to be tied to total debt levels and to the ability to sell
new debt at reasonable rates.
© Oliver Wyman 5Euro crisis 2.0
Nature of the recession’s cause garners sympathy for weaker EZ countries. The public in richer
Eurozone countries may prove more willing to allow actions to aid the weaker member states than
was true in the first Euro Crisis, due to the knowledge that a terrible pandemic is the cause of
much of the economic and financial difficulties. The first time around, many voters in the richer
nations viewed the Greeks, Italians, and other Southern Europeans as suffering from the effects
of their own profligate choices. This attitude poisoned the waters and made it more difficult to
reach consensus on aiding the troubled nations.
CRITICAL QUESTIONS
How bad will the Coronavirus Recession be in Europe? There remains a wide range of uncertainty
about just how bad the recession will be, which will be a major factor in determining how much
stress the Eurozone will face. A very bad recession would further reduce government revenues,
require substantially larger outlays to support households and businesses, and put strong
pressure on banking systems. One reason for the degree of my concern about the potential
for Euro Crisis 2.0 is that both official sector and private market consensus economic forecasts
appear to significantly understate the likely damage from the pandemic and the recession.
How far will moves towards fiscal federalism go? Many observers have noted from the Euro’s
inception that monetary integration without fiscal integration is a somewhat fragile construct.
Sharing a currency across countries or regions only works well if either the economies are
so similar that they are affected in the same way by any given shock or if there are adequate
adjustment mechanisms to counteract the differential impacts. The Euro Crisis demonstrated
that the lack of fiscal integration made adjustments much harder and therefore the EU took
some modest steps, such as by creating the European Stability Mechanism (ESM).
The Recovery Fund proposal is a major step towards fiscal integration within Europe. If passed,
it would represent the first time that the EU has borrowed against future revenue in the same
manner as nations do. Importantly, these funds would then be allocated to individual member
states in proportions more reflective of their needs than of the size of their contributions to
the EU budget. Again, this is similar to how a nation like the United States would borrow or tax
broadly and then allocate resources across its member states based on various criteria, including
the need for assistance.
The ability to borrow at the EU level and then allocate funds disproportionately among the
member states gives Europe much more fiscal flexibility to deal with sovereign debt crises at
the national level. At the extreme, this would make the creditworthiness of any member state
essentially the same as the creditworthiness of the whole EU.
© Oliver Wyman 6Euro crisis 2.0
However, we will be far from this extreme case, which leaves us with three key questions.
First, will the proposal become EU law and, if so, what modifications will be made in the process?
It will be a shock at this point if something is not finalized that looks at least moderately close
to the Commission’s proposal. Second, is this purely a one-off arrangement? The likelihood is that
this precedent will make future deals of this nature much more possible, but there is a chance
that this will be seen broadly as a one-off response to a once in a century health crisis. Third,
and related, how strongly will “solidarity” within Europe hold? In the positive case, the EU and
ECB policy responses will be seen as necessary and helpful, setting precedent for future actions.
In the negative case, nationalist spirit or clear cases of EU funds being misused or frittered away
on political pet projects or corruption could cause a rejection of this mechanism for the future.
How effectively has the Banking Union reduced the feedback loops between banks and
sovereigns? A major problem in the Euro Crisis was the close connection between the strength
of national governments and the strength of their banking sectors. Troubled countries saw big
increases in their credit spreads and therefore interest rates, which hurt their local economies and
slammed their banking systems. Banks that got into trouble undermined their local economies
by pulling back on lending and they often needed rescues from their national governments,
pushing up deficits. Europe responded by creating the European Banking Union, with institutions
such as the Single Supervisory Mechanism, housed in the ECB, and the Single Resolution Board.
This has worked successfully to improve the quality of regulation and supervision within the
Banking Union and, combined with actions by other institutions, has substantially improved
the resilience of national banking systems.
However, banks are still very closely tied to the fates of their national governments and economies.
First, banks are inherently levered plays on the economies to which they lend and the national
focus of most banks mean that they are hostage to the fortunes of their primary countries.
Second, banks continue to be required to hold large quantities of government bonds, very
largely those of the main country in which they operate. Therefore, when these bonds go down
in value, the economic value of banks goes down, even if accounting principles may defer or
obscure this reduction. Many stakeholders, including investors, respond to this economic hit,
whatever the accounting shows.
Sadly, it seems clear that this bank/sovereign nexus is still a source of serious risk.
How seriously will markets, and other stakeholders, take the threat of exits from the Euro?
Investors, lenders, and corporate managements have to take into account the potential for
one or more nations to fall out of the Eurozone, switching to a new version of their old national
currencies. Anyone investing or lending euros into a troubled country faces the risk that their
euros will come back as lire or drachmas or some other national currency. Any country that
switches out of the euro is highly likely to couple this change with a massive devaluation, in order
to make debt levels bearable again. Further, the transition is guaranteed to be a rough one,
even if it were to prove beneficial in the long run (which is by no means guaranteed).
© Oliver Wyman 7Euro crisis 2.0
My sense is that the redenomination risk is higher than in 2010 and that markets will perceive
it that way. One can’t “unring the bell” now that it has become a serious topic of discussion,
which it was not really at the beginning of the Euro Crisis. However, there is a reasonable
counterargument that the Euro Crisis has demonstrated that even very unhappy countries will
choose to stay in the Euro and that the other member states will do what it takes to ensure
that happens.
What will be the impact of the German Constitutional Court’s rulings on ECB’s powers?
Germany’s Constitutional Court, based in Karlsruhe, has ruled several times on the constitutionality,
in Germany, of the ECB’s more assertive use of monetary and financial policies. Up until now, the
rulings have laid down some constraints on the ECB, at least from a German point of view, but
not ones that kept the ECB from pursuing its policies.
However, in early May of this year, the Court ruled more aggressively than before, including
disregarding elements of a major ruling by the European Court of Justice on the basis that
the reasoning was so flawed as to not be a legitimate, binding exercise of the European Court
of Justice’s (ECJ) authority. (In general, the ECJ is the highest court of jurisdiction for issues
concerning the actions of European institutions.) The Deutsche Bundesbank has been ordered
not to participate in some of the ECB’s policies if the ECB does not provide sufficient justification,
in the Court’s eyes, within three months.
This is a very complicated issue which I cannot do justice to in a few paragraphs. My guess is
that Europe will once again avail itself of the finest constitutional lawyers in the world and will
find a way to work around the German court’s ruling without imperiling its policy objectives.
However, I could be wrong and, in any event, this is illustrative of the types of constraints that
could eventually keep the ECB from doing “whatever it takes” this time around. If the ECB were
to be viewed by markets as hobbled in any serious way, it would seriously harm perceptions of
the creditworthiness of the more fragile Eurozone member states, including Italy.
© Oliver Wyman 8Euro crisis 2.0
CONCLUSIONS
There is clearly a serious risk of a sequel to the Euro Crisis of 2010-2015. One’s views on the
likelihood and severity will depend on how one balances a number of factors that increase or
decrease the pressure. My own base case remains that there will be such a crisis, although I also
expect Europe to come out the other end of such a crisis without extreme damage, such as a
breakup of the Eurozone. That said, recent developments, such as the European Commission’s
proposal for a 750 billion euro Recovery Fund, are promising and reduce the risks somewhat.
If I revise my thinking in the near future, it will likely be towards greater optimism, although
there are clearly substantial risks in any case.
Douglas Elliott is an Oliver Wyman partner focused on the intersection of Finance and public policy.
He is the author of the book, Uncle Sam in Pinstripes: Evaluating US Federal Credit Programs. Prior
to his current position, he was a scholar at the Brookings Institution and a Visiting Scholar at the
IMF. Before that, he was the founder and principal researcher for the Center On Federal Financial
Institutions. He began his career with two decades as an investment banker, primarily at JP Morgan.
© Oliver Wyman 9Oliver Wyman is a global leader in management consulting that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. For more information, please contact the marketing department by phone at one of the following locations: Americas EMEA Asia Pacific +1 212 541 8100 +44 20 7333 8333 +65 6510 9700 AUTHOR Douglas J. Elliott Partner douglas.elliott@oliverwyman.com Copyright © 2020 Oliver Wyman All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. The report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. This report may not be sold without the written consent of Oliver Wyman. Oliver Wyman – A Marsh & McLennan Company www.oliverwyman.com
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