From ‘doom loop’ to ‘boom loop’
January 29, 2018
The euro area is currently experienced a strong upswing, GDP growth is above 2 % ; and even Italy, is experiences solid growth, after years of near stagnation. How can one explain this reversal of fortune? Until recently, the euro area seemed mired in a ‘doom loop’ of weak banks and weak sovereigns.
The key point is that self-reinforcing loops can work in both directions. During the crisis period of 2011/2, the self-reinforcing spiral was called the ‘doom loop’ because in countries under financial stress, weak banks cut credit, which created a recession, in turn putting pressure on government finances, which were already under stress because the banks needed public funding to cover their losses.
Such a doom loop can create its own dynamic whereby the expectations of default create ever-increasing risk premia bringing the economy to the brink of collapse, even if the underlying problems could be managed over time. When the gulf between the pessimism in financial markets and economic reality becomes too large, the market is ready for a turn-around. This was the case for the euro area during the summer of 2012. The assurance of the President of the ECB that he would not allow the euro to disintegrate ‘whatever it takes’, could have such a large impact because the fear in financial markets was in large part based on ‘fear itself’(to paraphrase President Roosevelt in 1933).
President Draghi’s intervention marked the start of a new cycle: the doom loop turned around and became a benign credit cycle in which lower risk premia allowed both banks and governments to refinance themselves at lower rates, making more credit available to the economy, whose recovery increased government revenues. In most of the euro periphery government were thus able to slow down drastically the accumulation of debt, without needing to cut expenditure any further. The positive credit cycle is less visible than the doom loop because cutting of borrowers and putting the economy into a recession takes much less time than to foster a recovery when credit becomes available again. Over-stretched borrowers are initially reluctant to spend and invest, even if they could. But easier credit conditions rarely fail to generate a recovery eventually.
Can the current benign cycle last much longer?
A similar self-reinforcing cycle of easy credit, growth and little pressure on government finances had also operated in the euro area until 2007/8. The key question is thus whether this current cycle will lead to similar excesses and end in a similar bust.
This is very unlikely since the growth pattern in the peripheral euro area countries is now very different. During the pre-crisis credit boom growth in Southern Europe was largely based on domestic demand, which was financed in turn by capital inflows. The crisis came when the capital inflows stopped suddenly. However, today’s growth in Spain, Portugal and Italy is based mainly on exports while domestic demand remains subdued. These countries are maintaining current account surpluses while their growth rates are picking up. They are thus no longer relying on capital inflows, which are always fickle, but on the contrary, they are repaying their external debt. Their new growth model is thus much more robust, and could continue until the remaining unemployment is absorbed.
No financial cycle lasts forever, but the present ‘boom loop’ driving the recovery of the euro area should have some time to run.