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Whack! Whack! WHACK! On a cold November night, a young man with a pickaxe conducts a brazen act of vandalism on one of the most recognizable monuments to the global political order. Jagged splinters of concrete fly alarmingly in all directions. A large hole appears. A few policemen even start to applaud knowing they are seriously outnumbered by cheering thousands. The world’s media looks on. Not your typical Thursday night out in late-1980s East Berlin then…

While TV audiences across Europe (mostly) cheered this seismic shift in the political and economic landscape,

few understood the painful effects to follow, at least in the short term.

As German reunification triggered an unexpected deluge of government spending, one that aimed to lift East German wages and infrastructure to West German standards, (a cost estimated today of EUR 1.5-2.0 trillion) so the Bundesbank raised interest rates. This mattered across Europe because the central plank of monetary policy at the time was the Exchange Rate Mechanism (ERM) which meant currency fluctuations between European countries had to stay within narrow bands. As the Bundesbank raised rates and the deutsche mark appreciated, other central banks had to do the same.

In the UK, the need to keep rates unreasonably high to maintain the value of the pound led to a deep recession, high unemployment and a 20% fall in house prices that took years to reverse. The whole saga famously ending in September 1992 with ‘Black Wednesday’, a USD 22 billion intervention in foreign exchange markets and a one-day jump in interest rates from 10% to 15%. Not only the Berlin Wall was rubble.

The damage went wider still; the Italian government pulled the lira out of the exchange mechanism, and Spain devalued the peseta. By May 1993, the Portuguese escudo and the Irish punt had also been devalued and, in August 1993, the currencies remaining in the ERM were allowed to fluctuate within a 15% band.

Please forgive my diversion into what, I am sure for many, feels like ancient history. I recount those times today with little fondness, despite all the good that ultimately followed reunification. As a young man at the time with a sketchy job and a large mortgage, I can tell you those splinters of concrete travelled painfully far.

But what of it? As we stumble into today’s earthshaking reworking of the global political and economic order, I cannot but help recall how difficult and painful the transition to a new world can be, whatever the ultimate destination. We might well be picking through the same mix of rubble (physical, economic and psychological) for a while yet.

On the plus side, while some try to bulldoze through trade and security arrangements that were decades in the making, Germany is once again swinging the big fiscal punches.¹ These hefty promises, if delivered, can certainly help address internal structural and military weaknesses to offset weaker export demand.

But

Germany is not Europe, nor Europe Germany

And it would be a serious mistake to conflate the two. Other countries’ ability to match the levels of spending and adjustments needed to thrive in a new world order seem very limited indeed.

Although Germany stands on the cusp of the second vast fiscal expansion in 35 years, it does so from a position of strength, with today’s debt levels at about 60% of GDP. The biggest hurdle to overcome has been psychological and its prior commitment to austerity (the so called black zero). Not so in France (115% debt/GDP and a 6.1% budget deficit) or Italy (139% debt/GDP and a 3.4% deficit), where prior fiscal profligacy and apparent inability (or unwillingness) to raise taxes, or cut spending, leaves them rather badly placed. And then there is the EU’s own Stability and Growth Pact (SGP)² which, although revised in 2024, still asks that countries respect the 3% deficit and 60% debt limit in EU treaties, albeit with longer adjustment periods.

Figure 1. Debt to GDP ratio in select EU countries, 1988 vs. 2024

Europe stands at a crossroads of lower potential growth from the headwinds of a trade war, a need to rearm as NATO security guarantees unravel and from a starting point of weak productivity and investment.³ And all this within an SGP framework that implies governments need to spend less, not more – how can all this be reconciled?

My answer: it probably can’t be, at least not without breaking some serious taboos. And that suggests a rocky road ahead for some Eurozone government bond markets.

Recall that in late 2024, French measures to address the budget deficit caused serious political instability which in turn led to a near doubling of the bond-market risk premium vs. Germany. Now growth will probably be even lower and borrowing costs higher, so the fiscal position is already more challenging than it was. I imagine that sometime over the next 12 months the fiscal credibility of some Eurozone governments will be seriously tested again. Perhaps even precipitating more volatility in bonds, just as we saw in France.

It is likely that, in the medium term, some form of debt mutualization⁴ is the only credible way out;

For me,

the question is when (not if) these events unfold, and how quickly.

If today’s trend towards a multi-polar world that rolls back the last 25 years of globalization continues, then greater debt mutualization in Europe will be inevitable if the EU is to survive.

At least three other points flow from this line of reasoning:

First, debt mutualization will need a far greater degree of fiscal union, one that will need treaty changes, EU central budget powers, an EU treasury function, a stronger bank support mechanism and probably moving decision-making from unanimity to qualified majority voting. If these are not politically achievable, any credible form of debt mutualization will fail and the European Union will be in serious jeopardy.

Second, just as the central bank targets and policy tools of the day proved unworkable during a huge structural event in 1992, so today’s European Central Bank mandate will need reworking to address the challenges ahead. A single focus on a 2% inflation target will not be nearly flexible enough to deliver good results over time.⁶

Finally, rebuilding European defenses and addressing real productivity challenges will require vast investment from the public and private sector. Large pools of domestic private capital will need to be mobilized in support. A world where investors care less about political goals, but prefer to move capital freely around the world in search of the best returns (i.e., the world of the last 25 years) will not be conducive. Some form of capital controls and constraints on the movement of money will probably follow. Politically, it is a very small step from tariffs on goods to tariffs on money when it flows the wrong way.

So plenty to think about.

The immediate cost of German reunification and the collapse of the ERM were painful for many, and the shockwaves travelled far. But the end result was an unmitigated good; a more unified Europe, millions freed from tyranny, a more prosperous continent. And the end of the ERM in the UK heralded the start of the recovery from the wreckage caused by high interest rates – the subsequent collapse in the pound brought an export and investment led recovery that sowed the seeds for a rapid cyclical rebound.

At the time, the Chancellor of the Exchequer was quoted infamously as having ‘sung in the bath’ on leaving the ERM.⁷ The comment was widely criticized as being insensitive to the economic turmoil unleashed. But he knew that breaking the economic orthodoxy of the day was crucial for a fresh start for the economy.

If today’s events lead to further progress towards more debt mutualization in the Eurozone, I expect finance ministers will again sing in the bath from Paris to Athens. I also believe their moment will come, but the recent history of Eurozone policy making suggests plenty of bond market discord in the meantime.

Recalcitrant hard-money northern Europeans wanting a low-cost path to a stronger continent might face the ultimate put down – “when the facts change, I change my mind. What do you do, sir?”⁸

Plenty to unpack, much to challenge, new ways to invest. That’s what The Red Thread is all about. See you there.

¹, Financial Times, Mar 5, 2025
², European Commission.
³, European Commission.
⁴ By debt mutualization in this context I mean pooling debt obligations across multiple countries. One could imagine a ‘federalization’ that implies transfer of debt responsibility from a lower level of government to a higher level (like the federal government). This might well also be a feature of the future landscape.
⁵, Social Europe, July 26, 2022.
⁶ In fact, this is probably also true around the developed world as we transition to a new global order – inflation targeting as practiced today will then join the list of other monetary policy regimes over the last 100 years that were forced to adjust to new political realities.
⁷, The Guardian, July 22, 2007.
⁸ Widely attributed to John Maynard Keynes.