They would surely pull back on spending and investment still further if the European situation went badly wrong. The combined effects of these four channels would almost certainly be enough to put us back in recession, although it is difficult to quantify the effects precisely, especially since there are numerous scenarios for exactly how the Euro Crisis could blow up.
Europe will probably muddle through, even though the process will be ugly and frightening. However, there is perhaps a one-in-four chance of a truly bad outcome, leading to a series of national defaults that include Greece, Portugal, Ireland, Spain, and Italy.
There is also a small chance of one or more countries leaving the Euro, which would create still more damage. My one-in-four probability estimate is necessarily a very rough one.
There are many different ways things could go wrong, since the eurozone is made up of 17 nations with their own political, economic, and financial systems.
Each risk has a low probability, but there are a multitude of those risks, so they add up. I have attached a short paper giving more details about the crisis, particularly why it is so hard to solve and how it may proceed from here. The actions expected to be announced this week may well improve the situation, but will be far from sufficient to resolve the core problems.
First, government leaders are unwilling to increase their national commitments to the European Financial Stability Facility beyond the previously agreed billion euros, which is clearly inadequate to reassure markets, especially since much of that is already committed. Therefore, they are looking for ways to leverage those funds to get closer to the 2 trillion euros or so of capacity that is really needed.
It appears this will be done by providing guarantees or insurance on a portion of the value of bonds issued by troubled eurozone countries. This is better than doing nothing, but is unlikely to restore markets in those countries to anything like normal operations.
The type of investors who would be lured by such guarantees are the ones who look for fat returns from somewhat riskier investments, which suggests that bringing them in will not appreciably reduce the interest rates paid by these governments.
Instead, government bond markets need the much larger capacity and liquidity provided by the kind of investors who look for safe, liquid investments. That will not happen without solving the underlying problems or providing guarantees backed by more creditworthy countries or multi-lateral bodies. Second, a bank recapitalization that adds approximately billion euros of capital is also a step forward, but, again, will not lay investor fears to rest.
The IMF recently estimated that sovereign debt problems had eaten away at least billion euros of economic capital from the European banks. Adding a figure half that large is unlikely to impress markets. Looked at another way, billion is about one-tenth of the approximately one trillion euros of capital already held by the 90 large European banks that would be subject to the new requirements.
In both cases, the ECB was mistakenly worried about the rise in headline inflation i. A temporary surge in commodity prices caused headline inflation to rise in both and —, though core inflation remained stable. Such confusion over inflation is a common problem for inflation-targeting central banks.
Instead of targeting inflation, central banks should target demand directly by targeting the growth path or level of total money spending on finished goods and services NGDP. There are several important reasons for this:. Under such a target, a period of catch-up in total money spending would occur and cause prices to temporarily rise. Prices would first rise in the core countries with the least excess capacity. Goods and services from the periphery countries would therefore become relatively cheaper, making them more competitive.
NGDP targeting would not solve all the deep structural problems that plague the Eurozone, but it would provide a monetary policy that does not push the currency union further into a recession.
It would also facilitate a more balanced recovery among the member countries. The Eurozone sorely needs such a monetary policy regime. Each week, we will send you the latest in publications, media, and events featuring Mercatus research and scholars. Skip to main content.
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Monetary Policy. Working Papers. Eventually, this fund was increased to about 1 trillion euros in February of Several other measures were implemented to stem the crisis as well. Rescue measures were highly criticized and unpopular in some nations such as Germany. These countries have larger and more successful economies. Countries receiving EFSF bailout funds were required to undergo harsh austerity measures.
These were designed to bring their budget deficits and government debt levels under control by reducing spending. Ultimately, this led to popular protests throughout , , and These culminated in the election of anti-bailout socialist leaders in France and Greece. The Eurozone Crisis was dealt with using bailouts, quantitative easing, and lower interest rates. Rich countries like Germany initially supported austerity measures designed to bring down debt levels.
In contrast, poorer countries facing financial problems complained that austerity only hindered economic growth prospects further. It also eliminated any possibility of "growing out" of the problem through economic improvement.
The so-called Eurobond was proposed as a radical solution. It was a security that would be jointly underwritten by all eurozone member states. These bonds would presumably have traded with a low yield; they would have enabled countries to more efficiently finance their way out of trouble. They also would have eliminated the need for additional expensive bailouts.
Some experts also believed that access to low-interest debt financing would eliminate the need for countries to undergo austerity and only push back an inevitable day of reckoning. The debate over how to deal with further eurozone financial crises continues. European Union. Accessed April 25, Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content. Create a personalised content profile. Measure ad performance.
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