THOSE old enough to remember the euro crisis of 2010-12 will have had a slight sense of déjà vu on June 15th, when the European Central Bank (ECB) called an emergency meeting. On the agenda were the widening differences, or spreads, in interest rates on government bonds of euro-zone countries compared with the benchmark German bund. Those spreads came down after the ECB promised to intervene with a yet-to-be-designed program. But fears of a euro crisis 2.0 have lingered. Highest on economists’ list of concerns is a so-called “doom loop” between different parts of the economy. What is a doom loop, and why are people so worried about it?
A country is at risk of a doom loop when a shock to one part of its economic system is amplified by its effect on another. In rich countries, central banks should have the power to halt such a vicious cycle by standing behind government debt, stabilizing financial markets or cutting interest rates to support the economy. But in the euro zone, the ECB can only do this to a degree for individual countries.
The riskiest link is between banks and governments. After the financial crisis in 2008, banks in highly indebted euro-zone countries started to buy large amounts of government debt. Between 2009 and 2015 in Spain, for example, banks increased their holdings of Spanish government bonds from around 2% of total assets to over 9%. National banks had an advantage over international rivals because politics made it harder for governments to default on them. But that created a two-way link: not only were governments exposed to risks from their banks; banks faced an immediate threat should the sovereign take a hit.
Severing that feedback loop has been a major goal of reforms in the euro zone. In 2012 the “banking union” was born. Under this, since late 2014 the ECB has been in charge of supervising the largest banks across the currency bloc. They are now in better shape, and so sovereigns are less exposed to banks’ risks. But the link has been weakened rather than eliminated. In particular, banks in Italy hold large amounts of Italian government paper, and are therefore vulnerable to a shock to Italian bonds.
The second part of the doom loop is between banks and the economy. Europe is a largely bank-based economy. A hit to the banking system that impairs its ability to lend to companies and households hurts the broader economy, and a weaker economy in turn leads more firms and households to default on their loans or mortgages, hurting banks again. Between 2008 and 2015, the share of non-performing loans owed to Italian banks rose from around 6% of total loans to 18%.
The third part of the loop links the sovereign and the economy. A government under financial stress may have to cut spending or raise taxes when the economy is weak. That in turn can aggregate fiscal problems.
The euro zone is at less risk from doom loops than it was ten years ago, thanks to reforms to the banking system, the ECB’s commitment to preserve the euro and some embryonic fiscal integration. But the danger has not disappeared. And reforms to the euro zone’s architecture that would further reduce the risk have stalled—in part because in 2012 the ECB boldly stepped in, easing the pressure on governments to make difficult decisions. As the ECB once again intervenes, the prospects for deep euro-zone reform look increasingly remote.