When money costs nothing, Europe’s debt is virtually free

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In Canada, credit card interest charges run at about 20 per cent a year. If the rate were close to zero, would you pile up more credit card debt? Of course you would.

Many European Union countries can borrow at historically low rates. In a few countries – Denmark and Switzerland, among them – policy rates are negative, meaning investors pay for the privilege of handing money to their treasuries. So aren't these countries borrowing like mad to invest in their economies to make them more competitive?

They are not. It's not often that a country gets money for nothing, or close to it, but instead of launching a spending spree on productive assets, from roads and hospitals to schools and scientific research, most European countries are obsessed with shrinking their budget deficits to reduce debt.

The mentality of German-inspired austerity, a hangover from the "debt" crisis that was triggered by Greece in 2009 and gripped Europe until 2012 or so, lives on. The health of the European economy, and its ability to create jobs, may suffer as a result.

Sovereign debt used to be expensive. In the early to mid-1990s, before the launch of the monetary union that replaced national currencies with the euro, bond spreads – the yield gap over benchmark German bonds – was often enormous. Investors in the bonds of Greece, Italy, Portugal and Spain, the traditionally weak countries on the EU's Mediterranean flank, were demanding yields five to 10 percentage points higher than those of equivalent German bonds.

Monetary union – one currency, one central bank – all but eliminated the spreads. By the early part of the last decade, sovereign bond yields had converged. Even the countries with uncompetitive economies, notably Greece, were able to borrow at virtually the same rate as Germany. It was this convergence that laid the foundation for the crisis to come. Weak countries borrowed with abandon and invested unwisely (Greece used it to pad its civil servant payrolls, lavishly). In spite of the growth in those countries, budget deficits and national debts soared.

After Lehman Brothers collapsed in 2008, the financial meltdown and the subsequent deep recessions exposed the frailty of the overleveraged economies. Bond yields soared as investors suddenly demanded high premiums in exchange for default risk. The spreads over German bonds in Greece, Italy, Portugal, Spain and Ireland climbed by five to 15 points, more so in Greece's case. Greece, Ireland and Portugal found themselves shut out of the debt markets, and Spain and Italy came close.

In mid-2012, with Greece on the verge of crashing out of the euro zone, European Central Bank president Mario Draghi swung into action. He promised to buy the bonds of any country that was having trouble financing itself. With the ECB's guarantee in place, bond yields reversed course. They kept falling as Europe slowly climbed out of recession. They plunged earlier this year, when the ECB unveiled a €1.1-trillion ($1.5-trillion) quantitative easing program, dominated by the purchase of public and private bonds.

By the early spring, many EU countries were paying less for 10-year money than Canada and the United States. This week, even after the recent yield surge, Germany's 10-year bond yield was still a lowly 0.6 per cent, Italy's was 1.8 per cent, down from a crisis peak of about 7 per cent, and Portugal's was 2.4 per cent.

Cheap money indeed, even when falling inflation was factored into the equation. But most EU governments have not treated it as manna from heaven. The mantra across the EU is, still, austerity and lots of it, even though the combination of spending cuts and tax increases is a proven growth killer.

Perversely, austerity demands more austerity. When government spending is reduced, gross domestic product – the denominator in the debt-to-GDP ratio – can stall, swelling the relative debt load. As debt (real and relative) rises, so does the desire to bring it down, which in turn demands more austerity.

The debt-to-GDP ratio of no-growth Italy is rising (albeit slowly) even as it trims its budget deficit. The Greek economy has been smothered by austerity, yet the EU and the International Monetary Fund are demanding more austerity, plus aggressive economic reforms, in return for another bailout package. Greece's new Syriza government is resisting austerity so vigorously that the country may have to default and leave the euro zone.

The other reason EU governments are not using the lure of cheap money to open the spending spigots is that large budget deficits under the EU's Growth and Stability Pact are, in effect, illegal. The pact limits budget deficits to 3 per cent of GDP and requires governments to achieve, eventually, a debt-to-GDP ratio of 60 per cent (both figures are exceeded by more than a few governments, including Britain's).

Why 3 per cent and not, say, 2 per cent or 4 per cent? Bizarrely, the number seems to have been picked out of thin air. A few years ago, a former senior budget ministry official in the French government of François Mitterand, who was president until 1995, told a French newspaper that the 3-per-cent figure "was a back-of-the-envelope calculation without any theoretical reflection. … We needed something simple."

It's absurd to have such tight deficit rules when sovereign debt is so cheap. The EU needs to deliver a jolt to the economy in the form of productive government spending. Instead, it's tightening up. No wonder EU growth is a global laggard and the euro zone's jobless rate remains stuck at about 11 per cent.