Is Europe on the Verge of a Depression, or a Great Inflation?

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

The news from Europe, particularly from within the euro zone, seems all bad.

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Interest rates on Italian government debt continue to rise. Attempts to put together a “rescue package” at the pan-European level repeatedly fall behind events. And the lack of leadership from Germany and France is palpable – where is the vision or the clarity of thought we would have had from Charles de Gaulle or Konrad Adenauer?

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In addition, the pessimists argue, because the troubled countries are locked into the euro, no good options are available. Gentle or even dramatic depreciation of the exchange rate for Greece or Portugal or Italy is not in the cards. As a result, it is hard to lower real wages so as to restore competitiveness and boost trade. This means that the debt burdens for these countries are likely to seem insurmountable for a long time. Hence default and global financial chaos seem likely.

According to the September 2011 edition of the Fiscal Monitor of the International Monetary Fund, 44.4 percent of Italian general government debt is held by nonresidents, i.e., presumably foreigners (see Statistical Table 9), on Page 72). The equivalent number for Greece is 57.4 percent, while for Portugal it is 60.5 percent.

And if you want to get really negative and think the problems could spread from Italy to France, keep in mind that 62.5 percent of French government debt is held by nonresidents. If Europe has a serious meltdown of sovereign debt values, there is no way that the problems will be confined just to that continent.

All of this is a serious possibility – and the lack of understanding at top European levels is deeply worrisome. No one has listened to the warnings of the last three years. Almost all the time since the collapse of Lehman Brothers has been wasted, in the sense that nothing was done to put government finances on a more sustainable footing.

But perhaps the pendulum of sentiment has swung too far, for one simple and perhaps not very comfortable reason.

There is no way to have just a little debt restructuring for Italy. If Italian debt involves serious credit risk – an end to the view that government debt has “no credit risk” and is a “risk-free asset,” with zero probability of default – then all sovereign debt in Europe will need to be repriced downward.

Will Germany will remain a safe haven? Even that is far from clear. According to the I.M.F., gross government debt in Germany will be 82.6 percent of gross domestic product at the end of this year (Statistical Table 7 of the Fiscal Monitor, on Page 70; the net government debt number for 2011, in Statistical Table 8, on Page 71,is 57.2 percent). Reports of German fiscal prudence have been greatly exaggerated.

German policy makers and the German public will not do well in the event of a major sovereign-credit disaster. Credit would tighten across the board. German exports would plummet. The famed German social safety net would come under great pressure.

There is an alternative to a decade of difficult austerity. The Germans could agree to allow the European Central Bank to provide “liquidity” support across the board to the troubled governments.

Many things are wrong with this policy – and it is exactly the kind of moral hazard-reinforcing measure that brought us to the current overindebted moment. None of us should be happy that Europe – and the world – has reached this point.

Among others, the bankers who bet big on moral hazard – i.e., massive government-backed bailouts – are about to win again. Perhaps the Europeans will be tougher on executives, boards and shareholders than the Obama administration was in early 2009, but most likely all the truly rich and powerful will do very well.

But if the German choice is global calamity or, effectively, the printing of money, which will they choose?

The European Central Bank has established a great deal of credibility with regard to keeping inflation at or close to 2 percent. It could probably offer a great deal of additional support – through creating money – without immediately causing inflation. And if the bank is providing a complete backstop to Italian government debt, the panic phase would be over.

None of this is a lasting solution, of course. Europe needs a proper fiscal center – much as the United States needed in 1787 and got under Alexander Hamilton’s policies from 1789. When he became Treasury secretary, the United States was in default and the credit system was almost completely broken. Some centralized tax revenue and control over fiscal deficits are needed.

Silvio Berlusconi stood in the way of all this. Other European leaders would not trust him to tighten Italian fiscal policy. But if he is really gone from power – and we should believe that only when we see it – there is now time and space for Italy to stabilize and, with the right help, find its way back to growth.

Of course, if the European Central Bank provides unconditional financial support to Italian, or other, politicians who refuse to bring their deficits under control, we are heading for another Great Inflation.

Italy on the brink as yields soar past point of no return

The eurozone debt crisis has again conformed to pattern this morning; just as one fire abates, temporarily at least – with news of the formation of a government of national unity in Greece – another lights up. Lamentably, this one – Italy – may be too big to douse.

The yield on ten year Italian debt rose to 6.59pc this morning, widening the spread on German bunds to an unprecedented 4.81pc. These are the sort of levels at which Greece, Ireland and Portugal began to find themselves shut out of markets.

Yet this time, there appears nothing there to offer support. The "enlarged" European Financial Stability Facility is not yet up and running. Few seem prepared to offer it the "leverage" required for the mooted €1 trillion of fire power. The European Central Bank under its new president, Mario Draghi, has said it's not its job to act as "lender of last resort" to governments. And the new funds that would allow the International Monetary Fund to step into the breach have not yet been agreed.

Internationally, moreover, there is growing resentment at being called apon to support further EFSF and IMF bailouts. Christine Lagarde, managing director of the IMF, could soon have a full scale rebellion on her hands. From China to Brazil, the now openly spoken mantra is that Europe should sort out its own problems. By what right does one of the world's richest regions call on poorer, and sometimes even more indebted, nations to lend support?

As my colleague, Ambrose Evans-Pritchard, points out in this morning's Daily Telegraph, the problem with Italy is not really one of contagion from the rest of the eurozone periphery. It's much more to do with the fact that Italy is sliding into deep recession, further undermining already stressed debt dynamics.

There's a vicious circle at work, whereby more austerity equals less demand, equals negative growth, equals an even bigger debt burden. Unlike Britain, there is no monetary policy and devaluation to counter the economically debilitating effect of the fiscal squeeze. With growing lack of competitiveness, Italy is in the wrong currency.

At his first press conference last week as ECB president, Mr Draghi said that further bond purchases would be "temporary", "limited" and "justified on the basis of restoring the functioning of meonetary policy transmission channels". At Jefferies International, chief economist David Owen takes the view that whatever Mr Draghi said last week, in practice he'll be forced to change tack and make the promise of "unlimited" buying explicit. But even if he did, would it really do the trick?

Mr Draghi would have preferred to exhaust conventional measures first, in particular cutting interest rates all the way down to 0.5pc, but conditions in the Italian bond market are deteriorating with such speed that he may not be allowed that luxury. When a fiscal crisis developes, it tends to happen very fast, with the rapid ebbing away of what remains of market confidence. That's the place Italy now finds itself in.

Eurozone policymakers think they are already moving at a speed which is only barely compatible with continued democratic support. Yet they are going to have to move even more swiftly towards the introduction of eurobonds and a centralised eurozone treasury function if they are to save the project. Germany and other rich, creditor eurozone nations are going to have to make up their minds; they wanted the euro, but are they prepared to do what it takes to sustain it?

The European Debt Crisis and the G-20 Summit Meeting

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

The April 2009 London summit meeting of the Group of 20 is widely regarded as a great success. The world’s largest economies agreed on an immediate coordinated approach to the global financial crisis then raging and promised to work together on banking reforms that would support growth. President Obama got high marks for his constructive engagement.

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The G-20 heads of government have met twice a year since then, and in Cannes this week they meet again. Could this meeting help stabilize the world economy? Can President Obama again play a leading role? The answer to both questions is likely to be no.

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In 2009, the primary problem was slumping economies in the United States and Western Europe. It was in the perceived individual interest of those economies to engage in some fiscal stimulus – and they were happy to present this as a joint approach. China was also willing to stimulate its economy, as its policy makers feared that slowing global trade would reduce Chinese exports. President Obama’s appeal for fiscal stimulus around the world was pushing on an open door.

Now the issue is quite different. We have a sovereign debt crisis within the euro zone, in which countries that have borrowed heavily are facing the prospect of restructuring their debts. The euro zone summit meeting last week established that Greek debt would fall by about half (relative to face value), although this does not clearly put Greece onto a sustainable debt path. Prime Minister Andreas Papandreou announced a plan on Monday for a referendum on the plan, a move with the potential to build political support for the needed reforms, and on Wednesday his cabinet offered its full support. But another outcome — if the government does not fall in the meantime, making the referendum plan moot — could be a Greek exit from the euro and a default on its debts in disorderly fashion, without any kind of international framework or outside financial support.

But the real issue is Italy, as it has been at least since the summer. The Europeans are only beginning to come to grips with the centrality of Italy in the European debt web – glance at Bill Marsh’s recent graphic to get the point. Italy has more than 1.9 trillion euros in debt outstanding; this is the third-largest bond market in the world. In the aftermath of the Greek referendum announcement, the yield on Italian debt rose above 6.1 percent. The standard view is that if this reaches 6.5 percent, Italy will need to seek assistance in the form of a backstop fund to guarantee there will be no default.

But the International Monetary Fund does not have enough resources available and the existing European Financial Stability Facility is also likely to be too small. People in the know talk of the need for more than two trillion euros in a “stabilization fund,” and while a lot of fuzzy math is involved in contemporary international financial rescues, the I.M.F. and the stability facility combined would be hard pressed to provide more than a third of that.

This might seem like a good time for a summit meeting – so the hat can be passed around among world leaders. And some people do hope that China can provide an enormous loan, either directly or working with the I.M.F. China, after all, has more than two trillion euros’ worth of reserves (not all in euros, of course; much of this is in dollars).

But it’s not clear China that wants to take the credit risk of lending directly – the Europeans might not repay, after all. And the United States is not keen to have China funnel such a large amount through the I.M.F.; this would undermine the traditional American predominance there. In today’s budgetary environment, there is no way that the United States can come up with anything like matching funds at a level that would make a difference – would you like to ask the House of Representatives for $100 billion right now to help keep Silvio Berlusconi in power?

And the heart of the problem is really European, not global. Specifically, the euro zone needs to address its underlying fiscal structure, which has become severely dysfunctional. It needs a proper fiscal union, with the right to tax and to issue debt – backed ultimately by the European Central Bank. And the ability of member governments to issue debt must be severely curtailed.

The United States faced a similar problem, long ago. The original Articles of Confederation proved inadequate, largely because there was no centralized fiscal authority. The Constitutional Convention convened in 1787 in large part because the United States had defaulted on its debts, incurred during the War of Independence – and there was no way forward without a new agreement among the original 13 states and greater fiscal powers (and more) for the federal government.

Europe needs the equivalent of a constitutional convention. But today’s financial markets move so much faster than 200 years ago, and the delay in Europe has already been excessive. The Europeans need to move fast. Will the Cannes summit meeting speed them up?

The 4-Trillion-Euro Fantasy

Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a principal in Salute Capital Management Ltd. Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

Some officials and former officials are taking the view that a large fund of financial support for troubled euro-zone nations could be decisive in stabilizing the situation. The headline numbers discussed are 2 trillion to 4 trillion euros — a large amount of money, given that the gross domestic product of Germany is 2.5 trillion euros and that of the entire euro zone around 9 trillion euros.

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This approach has some practical difficulties. The European Financial Stability Facility as currently devised has only around 240 billion euros available (and this will fall should more countries lose their AAA credit ratings). The International Monetary Fund, the only ready money at the global level, would be more than stretched to go “all in” at 300 billion euros.

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Never mind, say the optimists — we’ll get some “equity” from the stability fund and then leverage up by borrowing from the European Central Bank.

Such an approach, if it could get political approval, would buy time, in the sense that it would hold down interest rates on Italian government debt relative to their current trajectory. But leaving aside the question of whether the European Central Bank — and the Germans — would ever agree to provide this kind of leverage and ignoring legitimate concerns about the potential inflationary impact of such measures, could a 4 trillion-euro package, for example, stabilize the situation?

Think through the best-case scenario, in which the big package is put in place and, at least initially, believed to be credible. Proponents of this approach argue that the “market would be awed into submission”; business as usual would prevail, meaning that Italy and other potentially troubled sovereigns could resume borrowing at low interest rates; and the 4 trillion-euro fund would not actually need to be used.

This seems implausible. If the big government money shows up, and this pushes down yields on Italian government debt, what will the private-sector holders of that debt do? Some of them will sell, taking advantage of what they worry may be only a temporary respite and, for those who bought near the bottom, locking in a capital gain (as interest rates fall, bond prices rise).

So the European/International Monetary Fund bailout fund would acquire a significant amount of Italian, Portuguese, Spanish and other debt (including perhaps that of Greece and Ireland). If the credit used from this fund, with its central bank backing, reaches — let’s say — 1 trillion euros, how will the Germans feel about the situation?

Their worries will only be heightened by continuing budget deficits, made worse by recessions, throughout the periphery. Someone will need to finance those deficits, and the stabilization fund is likely to be the financier.

On current form, the Italians will have promised moderate austerity but delivered little. Stories about corruption in Italian public life — perhaps exaggerated but with more than a grain of truth — will become pervasive and continue to grate on northern European taxpayers.

In fall 1997, the International Monetary Fund — with the backing of the United States and Europe — provided what was then regarded as a substantial package of support to the Suharto government in Indonesia. But the government refused to close banks as agreed — and after one of President Suharto’s sons finally lost one failed bank, he immediately popped up with another banking license. Articles about Indonesian corruption and the ruling family were on front pages of major newspapers in the United States.

Donor fatigue set in. In January 1998, when the Indonesian government announced a budget that had slightly less austerity than planned, it was roundly castigated by the international community, setting off further sharp depreciation in Indonesia’s rupiah. This worsened the debt problems of Indonesia’s corporate sector, which had borrowed heavily and at short maturities in dollars.

Panic erupted, social unrest became increasingly manifest, and the real economy declined further.

Italy is not Indonesia, and Silvio Berlusconi is not President Suharto — who ended up leaving office. But the comparison still has value. Will the countries backing the enhanced and highly leveraged European Financial Stability Facility be willing to face substantial credit losses, i.e., actual and continuing transfers from their taxpayers to Italians and others?

Lech Walesa famously remarked that it was easier to make fish soup from fish than to do the reverse. So it is with fiscal crises — once fear prevails and markets start to think hard about the stress scenario, it is hard to solve the problem simply with reassuring words or financial support that never needs to be used.

Crisis veterans like to say, quoting former President Ernesto Zedillo of Mexico, that when markets overreact, policy needs to overreact in the stabilizing direction. But what really matters is not overreacting; it is making sure you do enough.

In Europe, the first thing peripheral governments need to do is stop accumulating debt, and quickly. Italian fiscal plans to balance the budget in 2012 look implausible, as they assume unrealistic growth. The planned Greek debt restructuring and increased taxes will not turn that economy around, nor prevent Greece from accumulating further debt. Despite all the reported austerity, the Irish government is still running a budget deficit near 12 percent of gross national product in 2011, while nominal G.N.P. actually declined in the first half of 2011.

Europe’s periphery also needs to recognize that it signed up to a currency union, and that requires a new approach to adjustment. Instead of having huge devaluations like those suffered in Mexico under Mr. Zedillo, in Indonesia under Mr. Suharto or in Poland under Mr. Walesa, Europe’s troubled nations need to raise competitiveness by reducing local costs.

That must primarily come through wage reductions and more competitive tax systems. In Ireland a pact with the major unions is preventing further wage reductions, while in Greece the government is strangling corporations with taxes in order to avoid deeper wage and spending cuts. The proposed Portuguese “fiscal devaluation” — meaning lower payroll taxes to reduce labor costs and an increase in the value-added tax to replace the revenue — looks like a weak attempt to avoid talking about the need to cut public spending and wages much more sharply in real, purchasing-power terms.

Putting in place a huge financial package is not enough. Policies have to adjust across the troubled euro-zone countries so that nations stop accumulating debt, and the periphery moves rapidly from being among the least competitive nations in the euro area to the most competitive — and this includes lower real wages, even if debts are restructured appropriately.

The European leadership is a long way from even recognizing this reality, let alone talking about it in public.

The 4 Trillion-Euro Fantasy

Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a principal in Salute Capital Management Ltd. Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

Some officials and former officials are taking the view that a large fund of financial support for troubled euro-zone nations could be decisive in stabilizing the situation. The headline numbers discussed are 2 trillion to 4 trillion euros — a large amount of money, given that the gross domestic product of Germany is 2.5 trillion euros and that of the entire euro zone around 9 trillion euros.

Today’s Economist

Perspectives from expert contributors.

This approach has some practical difficulties. The European Financial Stability Facility as currently devised has only around 240 billion euros available (and this will fall should more countries lose their AAA credit ratings). The International Monetary Fund, the only ready money at the global level, would be more than stretched to go “all in” at 300 billion euros.

Perspectives from expert contributors.

Never mind, say the optimists — we’ll get some “equity” from the stability fund and then leverage up by borrowing from the European Central Bank.

Such an approach, if it could get political approval, would buy time, in the sense that it would hold down interest rates on Italian government debt relative to their current trajectory. But leaving aside the question of whether the European Central Bank — and the Germans — would ever agree to provide this kind of leverage and ignoring legitimate concerns about the potential inflationary impact of such measures, could a 4 trillion-euro package, for example, stabilize the situation?

Think through the best-case scenario, in which the big package is put in place and, at least initially, believed to be credible. Proponents of this approach argue that the “market would be awed into submission”; business as usual would prevail, meaning that Italy and other potentially troubled sovereigns could resume borrowing at low interest rates; and the 4 trillion-euro fund would not actually need to be used.

This seems implausible. If the big government money shows up, and this pushes down yields on Italian government debt, what will the private-sector holders of that debt do? Some of them will sell, taking advantage of what they worry may be only a temporary respite and, for those who bought near the bottom, locking in a capital gain (as interest rates fall, bond prices rise).

So the European/International Monetary Fund bailout fund would acquire a significant amount of Italian, Portuguese, Spanish and other debt (including perhaps that of Greece and Ireland). If the credit used from this fund, with its central bank backing, reaches — let’s say — 1 trillion euros, how will the Germans feel about the situation?

Their worries will only be heightened by continuing budget deficits, made worse by recessions, throughout the periphery. Someone will need to finance those deficits, and the stabilization fund is likely to be the financier.

On current form, the Italians will have promised moderate austerity but delivered little. Stories about corruption in Italian public life — perhaps exaggerated but with more than a grain of truth — will become pervasive and continue to grate on northern European taxpayers.

In fall 1997, the International Monetary Fund — with the backing of the United States and Europe — provided what was then regarded as a substantial package of support to the Suharto government in Indonesia. But the government refused to close banks as agreed — and after one of President Suharto’s sons finally lost one failed bank, he immediately popped up with another banking license. Articles about Indonesian corruption and the ruling family were on front pages of major newspapers in the United States.

Donor fatigue set in. In January 1998, when the Indonesian government announced a budget that had slightly less austerity than planned, it was roundly castigated by the international community, setting off further sharp depreciation in Indonesia’s rupiah. This worsened the debt problems of Indonesia’s corporate sector, which had borrowed heavily and at short maturities in dollars.

Panic erupted, social unrest became increasingly manifest, and the real economy declined further.

Italy is not Indonesia, and Silvio Berlusconi is not President Suharto — who ended up leaving office. But the comparison still has value. Will the countries backing the enhanced and highly leveraged European Financial Stability Facility be willing to face substantial credit losses, i.e., actual and continuing transfers from their taxpayers to Italians and others?

Lech Walesa famously remarked that it was easier to make fish soup from fish than to do the reverse. So it is with fiscal crises — once fear prevails and markets start to think hard about the stress scenario, it is hard to solve the problem simply with reassuring words or financial support that never needs to be used.

Crisis veterans like to say, quoting former President Ernesto Zedillo of Mexico, that when markets overreact, policy needs to overreact in the stabilizing direction. But what really matters is not overreacting; it is making sure you do enough.

In Europe, the first thing peripheral governments need to do is stop accumulating debt, and quickly. Italian fiscal plans to balance the budget in 2012 look implausible, as they assume unrealistic growth. The planned Greek debt restructuring and increased taxes will not turn that economy around, nor prevent Greece from accumulating further debt. Despite all the reported austerity, the Irish government is still running a budget deficit near 12 percent of gross national product in 2011, while nominal G.N.P. actually declined in the first half of 2011.

Europe’s periphery also needs to recognize that it signed up to a currency union, and that requires a new approach to adjustment. Instead of having huge devaluations like those suffered in Mexico under Mr. Zedillo, in Indonesia under Mr. Suharto or in Poland under Mr. Walesa, Europe’s troubled nations need to raise competitiveness by reducing local costs.

That must primarily come through wage reductions and more competitive tax systems. In Ireland a pact with the major unions is preventing further wage reductions, while in Greece the government is strangling corporations with taxes in order to avoid deeper wage and spending cuts. The proposed Portuguese “fiscal devaluation” — meaning lower payroll taxes to reduce labor costs and an increase in the value-added tax to replace the revenue — looks like a weak attempt to avoid talking about the need to cut public spending and wages much more sharply in real, purchasing-power terms.

Putting in place a huge financial package is not enough. Policies have to adjust across the troubled euro-zone countries so that nations stop accumulating debt, and the periphery moves rapidly from being among the least competitive nations in the euro area to the most competitive — and this includes lower real wages, even if debts are restructured appropriately.

The European leadership is a long way from even recognizing this reality, let alone talking about it in public.