Debt Crisis in Europe Easing, but Not Over

The recent financial crisis was like many others in that it caused large increases in private and public debt. Some European countries experienced much larger increases than others. Economist Silvio Contessi and Senior Research Associate Li Li, both with the St. Louis Fed, examined the options countries typically have for reducing these debt burdens and found that most of the ways historically used to pay off such large debts don’t appear to be viable options today.

During a recession, increases in government spending and decreases in tax revenue create or increase deficits, causing debt-to-GDP ratios to quickly rise. Fast rising debt levels can cause the perceived risk of default to increase as well, as was the case with the so-called PIIGS countries (Portugal, Italy, Ireland, Greece and Spain) and other European nations. This perceived increase causes financial markets and investors to demand higher yields on the debt of these countries, making issuing debt more difficult or even imprudent. Portugal and Ireland, for example, stopped issuing debt almost entirely and turned to the European Union and the International Monetary Fund (IMF) for borrowing.

For the past few years, interest rates have been at favorably low levels, allowing interest payments on country debt to be at moderate levels. However, countries that experienced large run-ups in their debt as a result of the financial crisis will still need to find ways to reduce their debt-to-GDP ratios. Contessi and Li write that there are five ways in which large government debts have been worked out historically:

1. Inflation surprises, or realized inflation rates higher than those expected by consumers and firms. High inflation rates can help reduce the real burden of repaying the principal of the outstanding debt.
2. GDP growth. This reduces the debt-to-GDP ratio if it is larger than the growth rate of the debt outstanding, and also increases tax revenue.
3. Debt restructuring. This consists of partial or total default on outstanding debt.
4. Fiscal consolidation. This is achieved through a combination of higher taxes and lower spending and is sometimes called fiscal-adjustment austerity.
5. Financial repression. Examples include directed lending to governments by captive domestic audiences (such as pension funds), explicit or implicit limits on interest rates, regulation of international capital movements, and similar measures.

Recent data show that inflation and growth measures do not bode well for European countries. Contessi and Li note that inflation is trending downward, below the European Central Bank’s 2 percent target. In January, the IMF forecasted real GDP growth rates of only 1 percent for the euro area as a whole.

Greece experimented with debt restructuring in 2012. Private creditors of Greek government bonds accepted a 53.5 percent haircut on the face value of their bonds and could choose to swap their high-rate, short-maturity bonds for low-rate, long-maturity bonds.

European countries are currently proceeding with a mix of fiscal austerity and financial repression. Both measures slowly adjust debt-to-GDP ratios, but some progress in regaining debt sustainability is evident. For example, Ireland and Portugal began issuing treasury bonds and borrowing directly from financial markets again in 2013.

Contessi and Li write, “Whichever route is taken by each government, the road to sounder fiscal stability will probably be long and difficult.”

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