The worst of the euro crisis is yet to come
"The most disturbing aspect about the eurozone right now is that every crisis resolution strategy depends on a moderately strong economic recovery. The Greek programme was already in trouble when it was agreed six weeks ago. All the official forecasts were wrong.
The country is in a depression, and its debt dynamic is “out of control”, according to its new fiscal council. In Italy, the central bank expressed concern that the country’s austerity programme would have recessionary effects.
The European bank recapitalisation strategy – if you want to call it that – is also collapsing under the weight of the economic downturn. Last week saw a heated dispute between the International Monetary Fund and the eurozone governments over how much banks need to be recapitalised. The final figure for recapitalisation could be far higher than even the IMF’s estimates if the economy plunges back to recession..
The downturn began this summer, and appears to have gained momentum. Bank lending to the private sector has fallen for two months. Broad money supply is well below the reference rate. A widely followed purchasing managers’ survey points towards a decline in manufacturing activity in August. For all we know, the eurozone may already be in a recession right now.
The European Central Bank has been tightening monetary policy since the spring. Fiscal policy is contracting as governments rush to announce austerity programmes. Policymakers seem in no hurry to fix the problem.
The first, second and third priorities of European economic policy should be to stop and reverse the downturn. If they fail to achieve that, the eurozone’s crisis will end in catastrophe because every single resolution programme will be in danger of failing. Unfortunately, economic policy is utterly unprepared for an economic downturn.
Monetary policy is the most important tool at this stage because the ECB has the greatest room for manoeuvre. Inflation expectations have subsided. My favourite market-based measure is zero-coupon inflation swaps. They now point towards an undershoot of the ECB’s inflation target.
Instead, the present system of uncoordinated policies gives us contagious austerity with a contagious downturn, I would expect therefore that the downturn will hit the eurozone with full force, and without defence. When that happens, the eurozone crisis will turn ugly."
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