Saturday, December 10, 2011


Mario Draghi, the head of the European Central Bank, could resolve the Eurozone crisis simply by pushing the button on massive debt monetization--that is, the purchase of Eurozone sovereign debt in sufficient quantities to stabilize financial markets. In normal times, such an inflationary move would be anathema to anyone interested in long run economic growth and stability. These are not normal times. We face an epic debt crisis that threatens to destabilize global markets, constrain growth and tip the global economy into debt deflation. These threats may persist for years if not addressed vigorously at their root. If the ECB purchased massive Eurozone bonds, then moderate inflation would set in as the money supply in Europe expanded, debt loads would ease relative to GDP, and monetary expansion would accommodate growth.

In the most important (and fundamentally bearish) development of the week, Draghi moved strongly in the opposite direction. He not only ruled out monetary expansion through troubled debt purchases, he argued that such action would violate the ECB charter even if pursued indirectly--such as loaning money to the IMF to buy bonds--or through any other "legal tricks." It is hard to walk back from illegal.

The second most important development of the week involves downgrades and rumors of downgrades. Moody's downgraded the French megabanks Thursday night. And, S&P put essentially the entire Eurozone on negative watch on Monday. So, in the midst of a historic debt crisis both European banks and European sovereigns are facing a mass loss of creditworthiness. Experts suggest that France now faces a two notch downgrade, possibly very soon.

The market finds cause for optimism in the recent Eurozone agreement for consolidation of fiscal power in Brussels which may now accede to enhanced power over national finances within errant Eurozone nations. Frankly, it is hard for me to believe that any nation would cede fiscal power to such an extent. Even in the US, the federal government has very limited legal power over state finances. Yet, more fundamentally, this does absolutely nothing to help with the debt crisis at hand. I hate to dissent from market verdicts, but I think the equity market has gotten a little giddy here.

The good news is that Eurozone yields are down right now and that equity markets have responded favorably to the deal announced at the EU summit this week. We may have bought some time. But, I am convinced things got gloomier this week, not better.

The fundamental problem is this:

One lesson that the world has learned since the financial crisis of 2008 is that a contractionary fiscal policy means what it says: contraction. Since 2010, a Europe-wide experiment has conclusively falsified the idea that fiscal contractions are expansionary. August 2011 saw the largest monthly decrease in eurozone industrial production since September 2009, German exports fell sharply in October, and is predicting declines in eurozone GDP for late 2011 and early 2012.

I have argued this point many times over the past three years. The only way out of a debt crisis is rapid growth--and that requires high-payoff fiscal policy and monetary accommodation. The Eurozone is following the austerity mantra off the cliff.

In my forthcoming law review article, I address this issue head-on. In Taking Fiscal Policy Seriously I will articulate an optimal legal framework for the operation of fiscal policy in a globalized economy. This will build on my prior work in this area, Fear and Social Capitalism which argued in favor of a depoliticized fiscal policy to complement monetary policy.

1 comment:

  1. Will the Eurozone crisis drive the U.S. economy back into a meltdown scenario?