Monday, January 23, 2012

Europe’s Debt Crisis Is Still Likely to End Badly

by Simon Johnson

Bloomberg
January 23, 2012

There are two main schools of thought on what may happen next with Europe’s debt crisis. Some well-informed people strongly believe that everything will work out just fine, and without much of an economic slowdown. Other, equally well-informed people believe just as strongly that the euro area will break apart in a traumatic manner. When it comes to predicting Europe’s future, not many people occupy the middle ground.

The two poles now agree that the severity of the crisis largely comes down to Italy and the European Central Bank. The optimists argue that Mario Monti will save the day. Not only will Italy’s new prime minister push through some reasonable austerity measures, the optimists insist, he will also persuade Germany not to demand yet more budget cuts. The sympathy and support of the German government matters a great deal, primarily because of its influence with the ECB.

If we were still living under the “no bailout” conditions of the gold standard, as it actually operated before 1914, Italy would have no hope. The market has decided that Italy has too much debt and too little growth. As these expectations become more negative and interest rates rise, it becomes harder for Italy to issue new debt and make the required payments on existing obligations. Projected government debt levels become explosive.

Today’s world, of course, has moved far from the gold standard because central banks can provide credit and create money. The central banks are limited only by their credibility, or the level of confidence by the financial system that policy makers will keep inflation in check.

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