Deleveraging is taking place across the EU, so the story goes, with some countries more aggressively shedding debt than others. But even where this is true, the deleveraging story only really applies to the financial sector. Private, non-financial debt as a percentage of GDP has continued to grow in most EU countries, and according to Jamie Dannhauser of Lombard Street Research it is the rotten core of the Eurozone that threatens to drag everything else down with it.

Increase in non-financial debt

“Private non-financial sector debt has increased dramatically relative to GDP across the advanced world over the last thirty years, but especially since the late 1990s,” writes Dannhauser. “In the eurozone, excessive debts are more pervasive and more threatening in the non-financial business sector – this is where the rotten heart of Europe is to be found.”

private non-financial debt AME

change in nonfinancial debt to gdp

Spain safe from growth in non-financial debt

Non-financial debt grew rapidly in the run up to the crisis and has continued to rise in every European country except Spain, and there only because the pre-crisis levels had hit such ridiculous heights. There are only a couple of ways to deal with such monumental levels of debt, and Dannhauser thinks most of them are impractical. The first is default, but it’s clear that as long as no country leaves the Eurozone default won’t be allowed because of the effects it has on the rest of the monetary union. Deleveraging normally inhibits growth and appears not to be happening anyways.

Japan’s deflationary trap

The other option is devaluation, but this risks falling into the deflationary trap that Japan has spent the last twenty trying to get out of. “Japan’s experience since the early 1990s is a testament to the long-term damage that unresolved private sector debt problems can do to economic growth and investment returns,” writes Dannhauser. “The eurozone seems highly unlikely to escape this curse: no viable mechanism within EMU exists to deal with such extreme debt problems successfully; the political will to create one is lacking.”

According to Dannhauser, the EU is looking at as much as a decade of sustained deleveraging to fix its balance sheet, and the benefits of this correction won’t be felt from years to come, and that’s only if politicians are able to persuade voters to keep such painful policies in place. If his outlook is right, what may be more likely is the slow decline of Eurozone economies until some member states are eventually forced out.