BRUSSELS—The euro-zone economy is showing signs of sputtering to life, but doubts abound about whether growth can pick up.
A big reason economists are skeptical is the huge cargo tethered to the currency bloc's rear bumper: trillions of euros in private-sector debt accumulated over the previous decade that policy makers have done little to address.
In the U.S., households, corporations and banks entered the 2008 global financial crisis with at least as much debt as many nations across the Atlantic.
But a mix of measures—including government deficit spending, a flood of homeowner mortgage defaults and massive liquidity injections by the Federal Reserve—have helped chip away at this debt edifice, leaving the private sector ready to start expanding again. Europe, however, is far behind the U.S. in shrugging off its private-sector debts.
The burden of debt repayment means companies have less money to invest, households have less to spend and banks have less to lend.
While these debts are being slashed—deleveraging, as economists call it—euro-zone economic growth isn't expected to rise much for some time above the anemic 0.3% rate it posted for the second quarter.
Deleveraging in the euro-zone's banking sector may prove to be one of the most powerful brakes on growth in the coming years.
Economists at the Royal Bank of Scotland estimate euro-zone banks will have to reduce their balance sheets by more than €3 trillion ($4 trillion) over the next three to five years to meet stricter rules on capital and leverage coming into force.
"With a deleveraging process going on, it is very hard to have strong positive growth," said RBS economist Alberto Gallo.
The euro zone's biggest banks should be able to satisfy the new requirements mainly by raising capital from financial markets instead of reducing balance sheets, Mr. Gallo said. But small and midtier banks have been frozen out of capital markets.
They will likely need to pare their balance sheets, either by "run off"—allowing loans to mature and not replacing them—or by selling assets.
That process will cause asset prices to fall and restrict lending, particularly in Italy and Spain, where smaller banks form a large part of the financial system, Mr. Gallo said. Euro-zone officials have pushed many of the policies that have resulted in bank deleveraging with the aim of bolstering the balance sheets of the currency bloc's battered financial system.
They have insisted that bank capital ratios should be improved mainly through boosting capital, rather than primarily via balance-sheet reductions. But the problem in the periphery is that it isn't obvious where the money to recapitalize banks will come from.
Banks there don't have access to financial markets to raise capital. Their cash-strapped governments don't have the means to raise more capital. The European Stability Mechanism, the euro zone's rescue fund, also isn't big enough to do it—even if it were allowed to.
That means that banks may have to be recapitalized by forcing some bank creditors to convert their claims into equity. That is likely to push up funding costs for peripheral banks, sending lending rates higher.
Mr. Gallo said policies are needed to lower the cost of credit in the periphery. One promising start, he said: A lending program under discussion from the European Investment Bank, which could provide up to €100 billion in new credit for smaller businesses mainly in the periphery.
But, he added, "€100 billion is a small number when you compare it to €3 trillion," the amount that banks are still likely to trim off their balance sheets. Household debt, mainly mortgages, is the most enduring legacy of the real-estate bubble that hit the U.S. and parts of the euro zone.
But in the U.S., a wave of mortgage defaults and huge purchases of mortgage-backed securities by the Fed have helped slash the financial burden of mortgages.
Consumption in the U.S. has risen strongly since the crisis, and demand for housing has begun to rebound. But consumption in countries with large household debts—the Netherlands, Spain, Portugal and Ireland—has floundered since the crisis began.
Adding to the problems of the three latter countries is their heavily indebted corporate sectors. European Commission economists in April flagged Spain, Portugal, Ireland and Cyprus as countries grappling with an especially daunting combination of large household and corporate debts.
"Our analysis suggests that deleveraging pressure could be highest in Cyprus, Portugal and, although to a lesser extent, Spain," the economists wrote. "Deleveraging pressures in Ireland and the Netherlands could also be significant."
A glimmer of hope for Europe is that private-sector debts in Germany and, to a lesser extent, France, aren't particularly high. Growth in those two countries has prevented the floor from dropping out from under the broader euro-zone economy.
The relatively strong performance of the German and French economies in the second quarter may, in part, reflect those lighter debt loads. But looming in the background is government austerity, which has exacerbated the economic damage caused by lingering debts.
In the U.S., more flexible budget policy has helped the private-sector deleverage. In Europe, austerity is being imposed just as the private-sector also is trying to fix its balance sheet.
That means households, banks, businesses and the government are all trying to cut their debts at the same time in what economists say is a thoroughly toxic combination for growth.
wsj.com
A big reason economists are skeptical is the huge cargo tethered to the currency bloc's rear bumper: trillions of euros in private-sector debt accumulated over the previous decade that policy makers have done little to address.
In the U.S., households, corporations and banks entered the 2008 global financial crisis with at least as much debt as many nations across the Atlantic.
But a mix of measures—including government deficit spending, a flood of homeowner mortgage defaults and massive liquidity injections by the Federal Reserve—have helped chip away at this debt edifice, leaving the private sector ready to start expanding again. Europe, however, is far behind the U.S. in shrugging off its private-sector debts.
The burden of debt repayment means companies have less money to invest, households have less to spend and banks have less to lend.
While these debts are being slashed—deleveraging, as economists call it—euro-zone economic growth isn't expected to rise much for some time above the anemic 0.3% rate it posted for the second quarter.
Deleveraging in the euro-zone's banking sector may prove to be one of the most powerful brakes on growth in the coming years.
Economists at the Royal Bank of Scotland estimate euro-zone banks will have to reduce their balance sheets by more than €3 trillion ($4 trillion) over the next three to five years to meet stricter rules on capital and leverage coming into force.
"With a deleveraging process going on, it is very hard to have strong positive growth," said RBS economist Alberto Gallo.
The euro zone's biggest banks should be able to satisfy the new requirements mainly by raising capital from financial markets instead of reducing balance sheets, Mr. Gallo said. But small and midtier banks have been frozen out of capital markets.
They will likely need to pare their balance sheets, either by "run off"—allowing loans to mature and not replacing them—or by selling assets.
That process will cause asset prices to fall and restrict lending, particularly in Italy and Spain, where smaller banks form a large part of the financial system, Mr. Gallo said. Euro-zone officials have pushed many of the policies that have resulted in bank deleveraging with the aim of bolstering the balance sheets of the currency bloc's battered financial system.
They have insisted that bank capital ratios should be improved mainly through boosting capital, rather than primarily via balance-sheet reductions. But the problem in the periphery is that it isn't obvious where the money to recapitalize banks will come from.
Banks there don't have access to financial markets to raise capital. Their cash-strapped governments don't have the means to raise more capital. The European Stability Mechanism, the euro zone's rescue fund, also isn't big enough to do it—even if it were allowed to.
That means that banks may have to be recapitalized by forcing some bank creditors to convert their claims into equity. That is likely to push up funding costs for peripheral banks, sending lending rates higher.
Mr. Gallo said policies are needed to lower the cost of credit in the periphery. One promising start, he said: A lending program under discussion from the European Investment Bank, which could provide up to €100 billion in new credit for smaller businesses mainly in the periphery.
But, he added, "€100 billion is a small number when you compare it to €3 trillion," the amount that banks are still likely to trim off their balance sheets. Household debt, mainly mortgages, is the most enduring legacy of the real-estate bubble that hit the U.S. and parts of the euro zone.
But in the U.S., a wave of mortgage defaults and huge purchases of mortgage-backed securities by the Fed have helped slash the financial burden of mortgages.
Consumption in the U.S. has risen strongly since the crisis, and demand for housing has begun to rebound. But consumption in countries with large household debts—the Netherlands, Spain, Portugal and Ireland—has floundered since the crisis began.
Adding to the problems of the three latter countries is their heavily indebted corporate sectors. European Commission economists in April flagged Spain, Portugal, Ireland and Cyprus as countries grappling with an especially daunting combination of large household and corporate debts.
"Our analysis suggests that deleveraging pressure could be highest in Cyprus, Portugal and, although to a lesser extent, Spain," the economists wrote. "Deleveraging pressures in Ireland and the Netherlands could also be significant."
A glimmer of hope for Europe is that private-sector debts in Germany and, to a lesser extent, France, aren't particularly high. Growth in those two countries has prevented the floor from dropping out from under the broader euro-zone economy.
The relatively strong performance of the German and French economies in the second quarter may, in part, reflect those lighter debt loads. But looming in the background is government austerity, which has exacerbated the economic damage caused by lingering debts.
In the U.S., more flexible budget policy has helped the private-sector deleverage. In Europe, austerity is being imposed just as the private-sector also is trying to fix its balance sheet.
That means households, banks, businesses and the government are all trying to cut their debts at the same time in what economists say is a thoroughly toxic combination for growth.
wsj.com
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