Now that the European Central Bank has started the covert bail-out of Spain and Italy by buying up swaths of Spanish and Italian debt in secondary bond markets, analysts are beginning to fear that the associated conditionality (Berlusconi and Zapatero made under-the-table deals with ECB President Trichet to push through even more draconian austerity measures) will actually end up making matters worse.

As the New York Times writes in an analysis:

Some economists warn that forcing further cuts could push their teetering economies over the edge. And unlike Greece or Portugal, they are so big that any default might shatter the euro union for good.

"Italy has done everything asked of it -- it has cut left, right and center," said Yanis Varoufakis, an economist in Athens who has written widely on the euro zone's travails. "But if you keep cutting like this you start to cut into muscle, which affects your growth and your tax revenues."

Spain and Italy already have some of the lowest growth rates in the euro zone, with both expected to be below 1 percent this year. And official projections show little improvement coming next year.

Read the full article in the New York Times.

Good article in the New Statesman:

We have had yet another day of turmoil on the markets and yet another example of "kicking the can" by the eurozone's leaders. This morning, with great reluctance, the European Central Bank (ECB) started to buy Italian and Spanish government bonds to pacify panicked financial markets. It has worked today -- bond yields on Spanish and Italian paper have reduced -- but it won't hold for long.

In the last few days, the likes of Herman Van Rompuy and Economic Commissioner Olli Rehn have taken to the airwaves to state that the markets should not be attacking Italy and Spain. On paper, their credit-worthiness looks reasonably sound: Spain's debt to GDP ratio of 60 per cent is lower than that of Britain, Germany and France, while Italy runs, at 4.6 per cent in 2010, one of the lowest budget deficits in the EU.

But this doesn't matter. The banking sector crisis in Spain may not be finished yet, and the country is suffering from chronic unemployment levels. Italy's debt burden is 115 per cent, second only to Greece. More importantly, the markets know that the 21 per cent haircut on Greece's debt burden is probably just the start of large private sector losses, the price of reckless lending. A significant restructuring of Italian or Spanish debt would bankrupt numerous European banks. In particular, Franco-German banks are exposed to nearly €1 trillion of Spanish and Italian debt.

The bond market won't stabilise until the financial sector is satisfied that eurozone debts, or at least most of them, are underwritten. With Germany the largest and richest country, the responsibility for the eurozone's future lies with them, and with the choices facing the eurozone being expensive and politically toxic, this makes Angela Merkel the most powerful and most vulnerable player in the debt crisis.

Read the full article in the New Statesman.

An important observation in the Guardian echoes what we have been saying elsewhere for months: this debt crisis was never just a problem of the European periphery. From the very beginning, an existential crisis for Western capitalism was lurking beneath the surface, presenting itself in the first instance as a sovereign debt crisis in the European periphery (just like the previous financial crisis of 2008 initially presented itself as a credit crunch in the US housing market).

But, as the Guardian observes, "when the crisis reached Rome, it finally became impossible for Europe's leaders to write off the turmoil in bond markets as a problem of the "periphery" - little Greece, Ireland and Portugal." And with markets tumbling across the world, it's becoming increasingly clear that the crisis wasn't just limited to Europe either. We have just entered the second installment of the global financial crisis. It's going to be an ugly weak.

One of the scarier quotes I have read in a while: "The rapidity of the decline and its force now rivals almost anything we've seen in the post-war era ... We have fallen so far and so quickly that we are up there with the most vicious sell-offs."

The situation is no longer just scary. With last week's market panic ($2.5 trillion wiped off global stock markets), Italian and Spanish borrowing costs pushed closer and closer to the levels where Greece, Ireland and Portugal earlier required EU bailouts, and Standard & Poor's downgrading the US credit rating, we can now safely say that the next global financial crisis has begun. Markets in Asia and Europe to heavy hits today, and Wall Street opened sharply lower.

The New York Times ran an important article today outlining how the prospect of a US slowdown could push debt-ridden Europe over the edge. The conclusion of the article is in line with what we argued in our latest analysis of the euro zone debt crisis:

... the European Union must either move forward or backward.

Backward would mean a slow, complicated and expensive dismantling of the euro zone. Forward means "more Europe" -- more solidarity, more coordination of fiscal policies, of retirement ages and taxes. In the end, to keep the euro zone whole, the richer, more competitive countries will have to put their credibility and some of their cash behind the poorer ones, not just to buy their bonds but to give them time to restructure.

Read the full article here.

Interesting overview on the European debt crisis. Echoes the basic point we made in the cap-stone to our Europe in Crisis series last week:

Many experts argue that the E.U.'s model, which concentrated monetary policy in the European Central Bank (ECB) while leaving fiscal policy to individual member states, is inherently unsustainable, as it denies member states monetary policy levers with which to help their recoveries. This also makes deficit-funded fiscal stimulus harder, as monetary policy can be used to keep borrowing costs low. When different countries are hit differently by a recession, as has happened now, the common monetary authority will act in ways that help some countries but not others. The ECB has pursued tight monetary policy that may prevent inflation in high-growth states like Germany but could also be worsening the recession in Greece, Spain, and other struggling states.

Most view one of two options going forward as likely. One is that the euro zone will lose members like Greece, Spain and Italy, either by them just leaving or by a default by any one of them, which could unravel the whole monetary union. Barry Eichengreen, a Berkeley economist, has said this would lead to a huge bank run and the "mother of all financial crises." Another option is closer European fiscal union, so that fiscal policy can be coordinated at the continent level as well as monetary policy, bringing the E.U. closer to being a sovereign state.

Read the full article at Ezra Klein's blog at the Washington Post.

Allen, Eichengreen and Evans confirming what we observed in our analysis of the second Greek bailout of last month: it's the banks who profit from the deal, not Greece. In fact, this bailout will only further add to Greece's debt problems:

It may be hard to believe that the experts could be so ill- informed. The only other explanation is that the sole purpose of the exercise was to mislead. The banks can claim that they are taking a hit when in reality they can exchange bonds currently trading at hefty discounts for debt whose market value will be half in the form of AAA collateral. German parliamentarians can be told that the private sector was forced to "participate" in the Greek rescue when in fact, even after rescheduling maturities, those lenders will still receive a large fraction of their original interest payments.

This deal should be thrown out. In its place, the EU should create a real debt exchange with real haircuts for the banks and a significant reduction in Greece's debt stock.

The good news is that there will be an opportunity to change course. Greece's debt is still unsustainable, and it will have to be restructured again.

Read the full article at Bloomberg.

An interesting piece by Miguel Poiares Maduro, Director of the Global Governance Program at the European University Institute in Florence, Italy:

It took more than a year for Europe to do what everyone knew needed to be done to contain the Greek crisis, and it still may not be enough. For the approved measures do not provide the transparent and long-term commitment to restoring Greek finances that markets want to see.

That is the nature of European politics. The EU acts only when it is pressed to the wall. And, when it finally does do the right thing, it pretends not to be doing it. The reason is that European Union politics is mostly national politics, which addresses national issues with a European dimension, but not European issues. The EU's deep interdependence is lost in national politics, opening a gap between the scope and level of policies and where politics takes place. Europe's democratic deficit is less a gap between European institutions and European citizens than between national politics and European problems.

Consider the very different narratives that have emerged in Europe and the United States about the financial crisis. Both in the US and the EU, some spent more than they could afford, and others granted credit that they ought not to have granted. But Americans blame irresponsible banks, while Europeans blame irresponsible southern countries like Greece.

The reason for this disparity is the scope and level of the politics under which the narratives are framed. In the US, the problem is seen as a national problem regarding the actions of banks and individuals, while in Europe the problem is seen as one arising within some states and affecting other states.

Quite simply, EU politics has not kept pace with the scope and level of the Union's problems. This is what those who lament the EU's democratic deficit mean. No EU member state has yet to fully internalize the consequences for their democracy of the interdependence generated by integration.

Read the full article at Project Syndicate.

Europe in Crisis, Part I: The Age of Austerity
Europe in Crisis, Part II: China to the Rescue?
Europe in Crisis, Part III: The German Engine
Europe in Crisis, Part IV: The Brussels Behemoth
Europe in Crisis, Part V: Liberalism Under Fire
Europe in Crisis, Part VI: The Future of Europe

Since our last article in this series, Europe's crippling debt crisis has taken yet another series of dramatic turns. From the escalation of the Greek debt crisis to the sudden threat of contagion to Spain and Italy, it has become painfully obvious that Europe's crisis is nowhere near resolved. Last week's emergency meeting to authorize a second bailout of Greece may have brought temporary respite, but analysts now agree that the calm will be short-lived.

Having extensively analyzed in prior installments the various political, financial, socioeconomic and international challenges that lie at the heart of Europe's rapidly escalating predicament, the time has come to synthesize our conclusions and look forward: what can be done to lift the Old Continent out of crisis and catalyze a breakthrough into a genuine 21st century political economy? How, in other words, can Europe be saved?

In more ways than one, Europe is facing a decisive moment in its history. The economic crisis is forcing EU leaders to make a number of difficult political choices about how to deal with Greece's enormous debt, how to deal with Europe's own insolvent banks, how to cement unity between divided member states, and how to react to the (predicted) failure of austerity to produce growth and reduce debt levels.

These questions, however, seem to obscure a much larger meta-question. Essentially, Europe is facing a fairly simple dilemma: either it pursues a breakthrough towards an ever closer union, devising a form of economic government to compensate for the structural imbalances between core and periphery - or it faces a breakdown of the euro zone (and potentially the EU) into individual member states.

Continue reading "Europe in Crisis, Part VI: The Future of Europe" »

A very important article by the Guardian's economics editor:

Less than two weeks ago the leaders of the eurozone were looking forward to an August sunning themselves on the beach after concluding a deal that was supposed to resolve once and for all the debt crisis on the fringes of the single currency.

Now the euphoria seems a distant memory, redolent of Neville Chamberlain's "peace in our time" as the financial markets threaten two of the big beasts of monetary union - Italy and Spain.

As bond yields in both countries rose to levels not seen since monetary union was created more than a decade ago, Spain's prime minister, José Luis Rodríguez Zapatero, said he was postponing his three-week holiday to monitor economic developments. Italy's economics minister, Giulio Tremonti, called an emergency meeting to discuss how his country, which has the biggest national debt of any eurozone nation bar Greece, could cope with the speculative attacks.

Traditionally, Europe closes for business in August unless there is a good reason policymakers should be shackled to their desks. This year there is.

Read the full article here.