Europe’s Debt Crisis: A Different Viewpoint
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It is no secret that almost all of Europe is trapped in a bad combination of economic stagnation and high government debt. This combination makes for a very difficult puzzle to solve: policies that end the stagnation can easily increase the debt, while debt-reducing measures can easily make stagnation worse.
We know from experience, especially from the fiscal crisis during the Great Recession 15 years ago, that when governments and central banks are pressured by the debt market, they always choose to defend the solvency of government debt. Back then, this choice came at a very high price, with some countries suffering sharp declines in GDP while unemployment reached depression levels.
Given that Europe is now back in an eerily similar situation, what can this alternative debt analysis method tell us about how EU member-state governments will react if a new debt crisis breaks out?
To answer this question, we first need to acquaint ourselves with two methods for measuring the value of government debt. The first is called par value and is essentially the ‘book value’ of a government’s debt.
Its meaning is simple. Suppose that the Greek government sells €1 billion of its 10-year treasury note in January, with a promise of €50 million per year in yield. This translates to an annual interest rate of 5%.
Under the par-value method for calculating the size of government debt, the €1 billion will be worth €1 billion for the duration of its ten-year-long life. The owner of that debt earns his annual €50 million coupon, i.e., a 5% return on his investment. At the end of the ten years, the Greek government pays him back €1 billion. Everybody is happy.
However, suppose that after five years, the investor decides to sell his €1 billion worth of Greek treasury notes. If the market is ‘normal,’ someone will pay him what the par value says. Everybody is still happy.
But what happens if there is a decline in demand for Greek government debt? Suppose there is a weakening in investor confidence in the Greek government’s ability to honor its debt obligations. When the investor tries to sell his Greek government debt, he is only offered €900 million for the €1 billion worth of treasury notes.
The market now values Greek government debt at 90 cents to the euro. Not everybody is happy.
We refer to the price of the debt that was set by the debt market, i.e., the €900 million, as the market value of the debt.
It is easy to be deceived by the market value. Since it is less than the par value, one can easily get the impression that the government’s debt has fallen. However, this decline in value comes with a higher interest rate: the investor who purchased €1 billion worth of sovereign debt at 90 cents on the euro still gets the annual coupon payment of €50 million.
Unlike the first investor, who got 5% interest, this new investor earns 5.56%. This second investor is happy, but the government is not. Their problem is that the market has put upward pressure on the interest rates on their debt. This situation makes it more expensive for the government to issue new debt. To continue our Greek example, if the Department of the Treasury in Athens wanted to sell more debt at the time when the new investor bought the €1 billion in existing debt for €900 million, it would have to match the 5.56% interest rate that the new investor got.
The 5.56% is there because investors have less faith in the reliability of the Greek government as a debtor than investors did when they bought Greek debt at 5%. For this reason, we can use variations in the market value relative to the par value of government debt as an indicator of how investors feel about buying and owning—or not buying and owning—a government’s debt securities:
- If the market value exceeds the par value, there is relatively high demand for the government’s debt; there is downward pressure on interest rates;
- If the market value is below the par value, there is relatively low demand for the government’s debt; there is upward pressure on interest rates.
Table 1 reports the ratio between market value and par value for the sovereign debt of all 27 members of the European Union. For 25 of them, the data stretches back to 2020, a year when the market value consistently exceeded the par value. The largest excess market value applied to Belgian government debt, where the market price for €100 of par-value debt was €125.20; the market value was 125.2% of the par value.
In 2021, though, things started changing for the worse:
Table 1
As indicated by the column farthest to the right, there was a little bit of a rebound in market values in 2023, but for most EU states, it was not enough to increase market value to par value parity.
Table 1 has a great deal of information for us. As part of the fact that the market value of sovereign debt has gone down across the EU, we now know that there is a market-based upward pressure on interest rates on European sovereign debt. This makes it hard for the European Central Bank to cut its policy-setting interest rates any further; the ECB’s deposit facility, which was 4% two years ago, was lowered most recently in June and currently stands at 2%.
If the debt market continues to value the debt securities issued by EU member states below their par value, it will eventually force the ECB to start raising interest rates again. That change in their monetary policy could come even as the European economy in general remains trapped in its current stagnant state.
Higher policy-setting interest rates at a time when unemployment is high and there is no improvement in sight would further entrench Europe’s economic stagnation. However, if the ECB is forced to choose between, on the one hand, helping bring down unemployment and reignite economic growth and, on the other, protecting the solvency of member state government debt, the ECB will always choose the latter.
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