What is the “doom loop” in the euro zone?

Source: The post is based on the article “What is the “doom loop” in the euro zone?” published in The Economist on 11^th October 2022.

What is the News?

Recently, the European Central Bank (ECB) called an emergency meeting for a doom loop. Many economists have warned that Europe may be headed for a doom loop

What is a doom loop?

A doom loop is the circle of vulnerability where a country’s banking system can be severely hurt by volatility in the economy. A country is at risk of a doom loop when a shock to one part of its economic system is amplified by its effect on another.

How doom loop impact the economy?

The doom loop is the circle of vulnerability where a country’s banking system can be severely hurt by volatility in the price of the sovereign bonds they hold for reserves. Thus resulting in a contraction in lending provided by the banks.

This contraction in credit, in turn, slows the domestic economy, resulting in a further deterioration in the price of the sovereign’s bond issues.

A government under financial stress may have to cut spending or raise taxes when the economy is weak. That in turn can aggravate fiscal problems.

The circle can also be activated by external forces such as a slowdown in global economic activity due to natural recession or trade friction.

Why Euro Zone is more vulnerable to a doom loop?

1) In rich countries, central banks have the power to halt such a vicious cycle by standing behind government debt, stabilising financial markets or cutting interest rates to support the economy. But in the eurozone, the ECB can only do this to a degree for individual countries.

2) After the financial crisis in 2008, banks in highly indebted euro-zone countries started to buy large amounts of government debt. Between 2009 and 2015 in Spain, for example, banks increased their holdings of Spanish government bonds from around 2% of total assets to over 9%.