My book, upon which all is based

Published on 7th September 2023

After my presentation at the IES-IREF Summer School in Aix-en-Provence about the European Stability Mechanism and its dependency on France’s retaining its AA-rating, the French business website asked me a series of follow up questions, and here are the answers in English.

Here is a link to the French version:

1. What is shadow debt, and how does France compare to its neighbours in this regard ?

A shadow debt is one part of the shadow liabilities of EU member states that are not included by Eurostat in its definition of ‘General government gross debt’ or ‘GGGD’. GGGD is the direct debts of a member state government, its state agencies, and regional and municipal authorities.

GGGD is the anchor figure for calculation of a country’s Debt-to-GDP ratio, and of compliance with the Stability & Growth Pact and the Fiscal Stability Treaty.

GGGD misses out what is in the shadows:
1. Debts and risks created by entities like the EU itself, the European Investment Bank and the European Central Bank
2. Debts of transport, electricity, water and gas utilities and of national central banks, and risks created in financing schemes like InvestEU and the European Guarantee Fund

Debts comprise items like the debts of the EU itself and the debts of Eurozone national central banks in the TARGET2 payment system.

Risks include the liability to pay extra capital into the European Stability Mechanism.

Both types of ‘shadow liability’ remain the responsibility of the public.

At the end of 2021 France’s GGGD was €2.8 trillion and then its shadow debts were €0.9 trillion and its shadow contingent liabilities were €0.8 trillion, making €4.5 trillion altogether.

The equivalent figures for near neighbours were:
Germany: €2.5 trillion – €1.2 trillion – €1.0 trillion – €4.7 trillion
Italy: €2.7 trillion – €1.3 trillion – €0.6 trillion – €4.6 trillion
Spain: €1.4 trillion – €1.0 trillion – €0.4 trillion – €2.8 trillion
Belgium: €0.5 trillion – €0.2 trillion – €0.2 trillion – €0.9 trillion

2. When is it likely to be acknowledged by authorities ?

Never, if they can help it. They explain away the massive debts in the TARGET2 payment system as just accounting entries that do not reflect real debts, and that anyway the debts reside within the European System of Central Banks. They go on to explain that euro held within central banks is risk-free because it is ‘central bank money’ so it doesn’t matter.

The two explanations conflict: the first one makes out the problem does not exist, whereas the second one admits the problem exists but pretends it does not matter.

It does matter, because the legal structure of the euro means there is no genuine ‘central bank money’ in euro the way there is in pounds or dollars: a deposit in the Bundesbank does not carry the same risk as a deposit in the Banca d’Italia. It does matter which element within the European System of Central Banks your money is with.

3. Are private investors (especially bond buyers) oblivious to this problem, wouldn’t it be in their best interest to take it into account and price it in accurately ?

My understanding is that they are aware of the problem and wish it did not exist. They continue to accept, in their behaviour, the explanations of the European authorities (which are self-serving) and of the public credit rating agencies (who are under pressure to agree with the European authorities because they are licensed by them, and their revenue streams are contingent upon the approval of the European authorities).

Given that the European System of Central Banks owns and controls (as collateral held with it) such a large proportion of bond supply – giving them both a huge degree of market power and visibility of who owns what bonds – and given that there are legal restraints against short-selling these bonds, it is unviable to take and maintain a position against that of the authorities. The bond market in euro is not a free market but tending towards a monopsony – one in which there is only one genuine buyer, albeit that it comes to the market through the many members of the European System of Central Banks. It can also call on other European institutions like the EIB and ESM to act in concert with them.

So you have a major ambivalence: investors trade with one side of their head whilst trying to push away the knowledge in the other side of their head.

An individual investor’s excuses are that everyone else is doing the same as they are doing, and that the public credit rating agencies would downgrade the member states and the European institutions if anything was wrong.

The threat from Standard and Poor’s to downgrade France to AA- could have been a wake-up call, but S&P said that France’s debts had the ‘implicit support’ of Germany, which is the line taken by the authorities The point is not genuinely true, as investors know in the other side of their head, the one they try to keep asleep.

4. How can individual investors keep their portfolio at a safe distance from this massive timebomb ?

That is really difficult for investors within the EU, and worse still for ones in the Eurozone. They are usually obliged by regulation to hold large portfolios of ‘high quality liquid assets’, reduced if they hold public sector bonds: the European authorities have self-servingly set the rules to create a reluctant buyer, who is compelled to trade in the direction that the European authorities want the market to move anyway, and who gets an incentive to trade in that way (in the form of being permitted to hold a smaller portfolio of the ‘right’ bonds).

Investors outside the EU may have more discretion, but they may not. If things go wrong, it will affect all asset classes in EU currencies, like shares, securitized bonds, real estate. Do they avoid all assets in euro and EU member state currencies? That would be a very big call.

There is no easy answer when we are talking about the currency used by such a large bloc of the global economy, and where the proponents of it are invited to sit at same tables as those who represent genuine sovereign currencies like the dollar, yen, pound and Swiss franc. It would take considerable courage to decide to take a different view from that held by all of these central bankers, governments, and ratings agencies, and that may be an avenue open to very few.

5. Will the euro hold when the dominos fall and Germany is asked to foot the bill ?

Here we get to the reason why S&P did not downgrade France to AA-: the ‘implicit support’ of Germany for France’s ability to meet its liabilities. That’s a humiliation for France, isn’t it? Relying on the country that invaded it three times in the last 150 years? Where does that leave the dignity of the French state? What flaccid bunch of énarques has brought that about? Is that what the EU and euro were for? No, they were for ‘la gloire’ to re-emerge.

For ‘implicit’ support read ‘doubtful’ – there is no legal obligation on Germany to pay France’s debts as well as its own. Political considerations would supposedly cause it to. Really? Even if it wanted to, does Germany have the necessary resources? Is it good for over €9 trillion all-in, or indeed for as much as €20 trillion if Germany ‘implicitly supports’ all the Eurozone member state debts, admitted and shadow, and contingent liabilities as well? That would be over five or six times the size of its whole economy. Even Greece’s debt is only 193% of the size of its economy and that merits it having a Standard and Poor’s credit rating of BB+ (denoting a speculative investment with a substantial risk of loss).

If Germany was responsible for such a massive amount of debt, its credit rating should be nearer to the CCC level – junk with a very high risk of loss.

That’s the problem. Germany enjoys a AAA rating because the rating agencies in one breath consider it in isolation, and in the next breath they wheel in Germany’s implicit support to justify maintaining inflated ratings for other Eurozone member states, without adding that member state’s debts onto Germany’s and adjusting Germany’s rating downwards.

The bureacrats’ answer to the dominos falling will be to try and push through what they have always wanted: the political fusing of the entire EU into a single polity using the euro, with a unified tax system and every citizen being equally responsible for all public debts and liabilities. Then the euro would become what it is not now, a genuine currency with its own ‘central bank money’.

Germany’s gold reserves would be moved around in Frankfurt to become the property of the ECB i.e. the property of everyone in the EU.

Can you imagine that being allowed to happen without popular violence? A real civil war, in which a few thousand bureaucrats try to get the German police and army to crack down on its 80 million citizens? The risks are not just the euro breaking up, but a complete societal breakdown in EU member states, to which the European institutions are too weak to stand up, their being a creature of the member states. It will quickly devolve back to the member states to decide in which way they want to move, and that automatically spells the end of the European Commission as a supreme authority body, the end of the European Court of Justice as the supreme law-adjudication body, the end of the relevance of the European Parliament and so on. Who needs the euro then?