Schadenfreude is unwise: Europe will be next to suffer

The EU dismissed the financial crisis as an Anglosaxon problem. This time, it should show humility

Schadenfreude in European capitals is ill-advised. A string of states will face their own rude awakening soon enough as global liquidity drains away and financial conditions tighten.

Eurozone debt ratios are on average higher than in the UK. Primary deficits are mostly comparable even after Kwasi Kwarteng’s mini-budget. Energy rescue packages are similar in scale.

The eurozone is entering a recession that will be at least as deep. The €-coin measure of underlying growth is currently weaker than during the depths of the European debt crisis a decade ago.

The British government is at least capable of U-turns. The institutional framework of monetary union is an order of magnitude more dysfunctional. Let us not forget the policy death march of Europe’s “lost decade”: a stubborn reliance on “internal devaluations” and austerity waterboarding that prolonged the misery.

The European Systemic Risk Board has issued its first general warning since the body’s creation after the Lehman crisis, flagging “severe risks to financial stability”.

The ESBR said Europe’s credit system is coming under threat from multiple directions. The energy shock is colliding with a worldwide interest rate shock just as the European housing cycle rolls over. “These risks may materialise simultaneously, thereby interacting with each other and mutually amplifying their impact,” it said.

Michael Wilson, Morgan Stanley’s global equity guru, said world liquidity has already shrunk by $4 trillion (£3.6 trillion) since peaking in March, as measured by M2 in dollars. Money figures are now in the “danger zone” where financial accidents begin to happen. “This is how it starts,” he said.

Vanishing liquidity is disciplining any country seen to be living beyond its means, which is why it was so unwise of Liz Truss to push her fiscal luck. Wilson said ructions in the UK’S gilts market are the canary in the global coal mine. Other countries will be sanctioned in turn and other central banks may have to intervene to save the day.

Yes, the Bank of England has been forced to rescue an impetuous Chancellor but it has not yet crossed the line into fiscal dominance, or reverted to quantitative easing.

The European Central Bank crossed many lines a long time ago and is already a captive fiscal agent. It is currently buying Italian bonds on a large scale to prevent borrowing costs spiralling out of control, even though eurozone inflation is 10pc.

The Italian bailout is not a one-off liquidity measure in extremis. It amounts to continuous monetary financing of a budget deficit. Italy would face a full-blown debt crisis in current circumstances if the ECB even hinted at the withdrawal of this backstop.

“Where fiscal dominance is concerned, the eurozone is much further down the road than the UK. Italy exhausted its fiscal space long ago,” said Robin Brooks, chief economist at the Institute of International Finance.

Italy’s 10-year yields surged to 4.9pc amid contagion from the British mini-budget. They have since dropped back to 4.2pc but this is still untenable for a country that combines a public debt ratio of 151pc, a fiscal deficit of 6pc (IMF data), chronically low growth, and an incoming hard-right coalition that campaigned on its own version of Trussonomics.

“At this level of yields, it would not take much to get Italy into trouble. Spreads are no longer the issue. The level of rates is,” said Ruben Seguracayuela from Bank of America.

He warned that Giorgia Meloni risks setting off “dangerous dynamics” if her government backs away from an earlier national commitment to achieve a “primary” budget surplus. Bank of America says any misstep could force the ECB to activate its untested new bailout tool (TPI) within weeks.

The eurozone’s doom-loop of sovereign states and commercial banks taking each other down in a destructive vortex has been in remission. It has not gone away. The ECB’S QE has kept it alive. It encouraged southern European banks to buy their own country’s debt to earn easy money on the carry trade. They now face mark-tomarket losses on these holdings, straining capital ratios.

Germany is splashing €200bn on its energy package, of which roughly €150bn will come from borrowing. The German state can afford: others cannot afford it. The political fallout is toxic.

Germany has once again chosen to flout the principle of collective EU action and go it alone in a crisis, prompting protests from Italy’s Mario Draghi and the wrath of the European Commission. As always, Brussels has its own empire-building agenda, aiming to capitalise on the energy shock to entrench the precedent of joint debt issuance and advance the ideological cause of fiscal union.

France has mostly escaped market scrutiny even though the International Monetary Fund’s fiscal monitor shows that its public debt is 113pc of GDP – versus 88pc for the UK – and that its public finances are on the worst trajectory of the OECD Club. Philippe Gudin, from Barclays, said Macron is relying on implausible assumptions of French, European and global growth. Early-warning data show that the French economy is already sliding into recession. This is likely to push the deficit to 5.7pc next year.

Gas and electricity prices have essentially been frozen, shielding rich and poor alike. Electricity bills will rise just 15pc in January 2023. Macron has also held down petrol prices by 30 cents a litre even though there is no global oil shock. These subsidies have flattered France’s inflation rate but they are exactly what the IMF says you should not do.

Home-made nuclear power makes these subsidies less ruinously expensive than they would be for some countries. However, 32 of France’s reactors are out of service. EDF is buying power on the European market, a fair chunk from the UK via interconnectors, often at exorbitant day-ahead prices.

Gudin thinks the energy bailout will approach €100bn over 2022-2023. “We think the cost of these measures could have been minimised through better targeting low-income households and better incentives to reduce energy consumption,” he said.

When the first tremors of the global financial crisis began in 2007, Europeans dismissed the stress as an Anglo-saxon problem and a deformity of speculative capitalism. It was only when Lehman Brothers and AIG collapsed that they suddenly understood that European banks were on the hook for America’s subprime debt. Even then they ridiculed warnings that they faced their own “subprime” disaster in Club Med sovereign debt.

They did not understand that they too had been lured into the great global credit boom of the early 2000s. What ensued was an intractable crisis of the European political economy for seven years, long after the Anglo-saxons had recovered. It was a harsh lesson. A little humility in Europe might be advised.