Simon Nixon / Oct 2024
Image: Shutterstock
Latvia, where I recently spent a few days, may not be the most obvious place to go to ponder the troubles faced by the European economy. But it turns out to be as good a place as any. One of the eurozone’s smallest economies turns out to be the most extreme exemplar of one of the biggest problems holding back the entire bloc: a crippling aversion to risk that permeates the blocs economic and social model. In Latvia this risk aversion is manifested both in a banking system that is barely serving the needs of the domestic economy and the absence of alternative market-based sources of capital to finance investment in promising businesses.
The problem was succinctly spelled out by Martins Kazacs, the Governor of Latvia’s central bank, in his presentation to the conference that he was hosting. He noted that Latvian bank lending amounted to a risible 28 per cent of GDP, far below the eurozone average of 76 per cent. Yet despite this low level of lending, Latvian banks had some of the highest loan charges, lowest bad debt levels and highest margins and returns on capital employed anywhere in the European banking system.
You would think that in a functioning European single market, such a lucrative market would draw in new entrants eager to take market share whether by offering cheaper loans or by extending credit to those excluded by the incumbents. The loan rejection rate is four time higher in Latvia than the eurozone average. Yet this isn’t happening. Nor is it happening in Latvia’s Baltic neighbours, Lithuania and Estonia, which share many of the same characteristics, the three topping the eurozone banking league tables for return on equity. Why on earth not?
Before answering that question, it is worth noting why this matters.
Across Europe, warning lights on the economy are flashing red. After two years of worrying about inflation, European policymakers are starting to sound the alarm on growth. America had its growth wobble over the summer, prompting Federal Reserve to cut interest rates by 0.5 percentage points last month; fears over Chinese growth led to a big intervention by the authorities last week. Now it is Europe’s deteriorating outlook that is the spotlight. As Isabel Schnabel, usually regarded as one of the most hawkish members of the European Central Bank’s executive board, noted in a hard-hitting speech last week, the eurozone is stagnating: over the last two years real GDP has grown by an average of just 0.1 per cent per quarter.
No Motion Crisis
This stagnation is increasingly reflected in market forecasts which assume that the ECB will cut interest rates further and faster than previously forecast, particularly after inflation fell below target to 1.7 per cent in September. The market is now betting that the central bank will bring forward a 0.25 percentage cut to 3.25 per cent previously expected in December to its meeting this month, with a further cut before the end of the year. Indeed, the market now expects eurozone interest rates to fall to 1.75 per cent before the end of next year, a sharp turnaround from previous forecasts that they would ultimately settle somewhere between 2 and 3 per cent.
What worries eurozone policymakers is that interest rate cuts alone may not be sufficient to reverse this stagnation. As Schnabel notes, the stagnation began well before interest rates to in response to the inflation spike. Between 2017 and 2021, German output rose only one per cent in real terms. What’s more, even where growth is stronger, it may not be all that it seems. The five fastest growing member states just happen to be the biggest recipients of EU funds under its post pandemic recovery programme. Spain’s growth is flattered by high levels of immigration. Other countries have been running large budget deficits, including Italy at 7 per cent of GDP and France at 6 per cent, which now need to be reined in.
But as Latvia’s moribund banking system highlights, interest rate cuts are only as effective in stimulating economic activity as the financial system through which they operate. Sure, lower borrowing costs should encourage households and firms with existing loans to spend more, but to really juice growth and raise living standards you need customers to take out new loans to fund potentially productive investments. That requires people willing to take risk and a financial system willing to fund it.
Yet eurozone banks are failing on this score, in part as a result of over-zealous post-financial crisis regulation. Net new lending by the banking system has barely grown over the last decade and a half. The private credit market, which is filling the gap left by banks, is half the size in Europe as in America. Meanwhile, capital markets are underdeveloped: investments in equity and bond markets by households, pension funds and insurance companies is between 130 and 200 per cent of GDP in most eurozone countries, compared to 525 per cent in the US.
It is these structural issues that Europe needs to address if it is to pull itself out of stagnation. In his recent 400 page report on how to restore the EU’s competitiveness, Mario Draghi framed the central challenge as the need to unlock innovation, particularly in technology where Europe has fallen far behind America and China. But the key to doing that is to overcome the extreme risk aversion which pervades every aspect of the European economy. That does not require billions of euros of new EU funding or the issuance of new common debt. But it does require Europe to undertake reforms of its financial system and change its approach to regulation.
The Latvian Problem
The first imperative is to tackle the Latvian problem by making it far easier for banks to operate cross-border within the eurozone. Currently barely 20 per cent of lending within the EU’s nominally single market is cross-border. One way to facilitate more cross-border lending is to encourage the development of cross-border banks. It is striking that America’s largest bank, JP Morgan, has a bigger market capitalisation than the top eurozone banks put together.
Deeper banking integration would require the EU finally to complete its banking union by agreeing measures such as the long-debated common deposit insurance system. This would allow failed banks to be wound up at European level, rather than costs falling on national systems. That would remove one excuse for governments to block mergers. Another imperative is to harmonise national rules around consumer protection, insolvency and employment which are used as covert protectionism.
The second challenge is to convince eurozone citizens to take more risk by investing more of their savings in equities, thereby providing a deeper pool of capital to fund innovative companies. This should be in citizens’ self-interest. As Draghi noted in his report, Europeans save more than Americans but are poorer than Americans, largely because they tend to save in low risk government bonds and deposit accounts.
In 2022, EU household savings were EUR 1,390 billion compared with EUR 840 billion in the US, reflecting the lower savings rate of US households, which is around a quarter of the EU level. However, despite their higher savings, EU households have considerably lower wealth than their US counterparts, largely because of the lower returns they receive from financial markets on their asset holdings. Between 2009 and 2023, net household wealth increased by 151% in the US, compared with only 55% in the euro area… Financial securities (listed shares, bonds, mutual funds and derivatives) directly held by households alone currently account for 43% of US household wealth, but only 17% of EU household wealth.
One way to encourage more risk-taking is to reform Europe’s pensions systems, as Latvia has done. It has created a second pillar to its state pension system in which part of worker’s salaries are invested in equities. But most European pension systems remain pay-as-you-go schemes funded out of general taxation. As Draghi noted, in 2022 the level of pension assets in the EU was only 32% of GDP, compared to 142% in the US and 100% in Britain. Meanwhile, forging ahead with the EU’s similarly long-debated capital markets union, now rebranded as the savings and investment union, could significantly reduce costs for both savers and issuers by creating more standardisation across capital markets and encouraging common infrastructure.
Nonetheless, there is a chicken and egg quality to debates about capital markets union: what comes first, the money or the investment opportunities? As I noted in a recent post on the success of the Swedish stock market, it helps to have a thriving ecosystem of start-ups. That is why measures to address the high degree of risk aversion baked into the EU’s regulatory structures are essential, as Draghi made clear.
That risk aversion is most notoriously reflected in the precautionary principle, embedded in the EU Treaties, whereby activities are banned where the possibility that they might cause harm is suspected even if there is no proof. This has informed Brussel’s approach to a range of sectors, from chemicals and foods, to banks and most recently AI. But the problem does not just lie at an EU level. Many of Europe’s biggest barriers to risk-taking lie in national regulations which are often used as form of protectionism to shield incumbents from competition.
Political Costs
What are the chances of Europe adopting such an approach? That the German government is threatening to block a possible takeover of Commerzbank by Italy’s UniCredit sends a very bad signal, as previously noted, made worse by the fact that Berlin has been the primary obstacle to a deal on a common deposit insurance scheme. Indeed, Germany’s disappointing response highlights the extent to which so much of Europe’s risk aversion is thinly disguised protectionism for the benefit of powerful vested interests among employers and unions. But exposing citizens used to high levels of protection whether in their pensions or their workplace to more risk is bound to create political risks for any government.
Yet not acting carries a political cost too, and it is rising all the time, as France is discovering. Low growth is compounding Europe’s fiscal challenges, making it harder for governments to rein in budget deficits. The current growth crisis comes at time when the eurozone is trying to reassert its fiscal rules for the first time in five years. Already a vicious circle is developing whereby stagnation is fuelling support for populists, increasing political fragmentation and making reforms harder to deliver.
What happens if this vicious circle is not broken and the stagnation persists? The worst case is that the ECB is eventually called upon once again to resume buying bonds, whether to try to boost growth or cap a country’s borrowing costs - only this time against a likely backdrop of deteriorating market confidence in the euro’s fiscal framework, reigniting questions over its viability. No wonder eurozone policymakers are nervous. That is not a risk that any one in Europe should want to take.
Simon Nixon writes the Wealth of Nations newsletter on Substack
