We are all focused on the travails of Greece, the sovereign debt crisis in the eurozone and the fear that the euro project might well be heading towards collapse under the pressure of fiscal austerity on the one hand and populist protest on the other.
The euro will collapse or not collapse – the outcomes are binary. There is no half-survival outcome – the creation of a super-euro around Germany is equivalent to the collapse of the existing euro.
However, I’m pretty sure the euro won’t collapse before the policy response that produces the risk-on environment.
Expected triggers
The policy triggers I look for are: intervention by the European Central Bank to stabilize the euro debt crisis; a Europe-wide solution to recapitalizing the banks; more quantitative easing in the US and Japan; confirmation by the eurozone authorities that their growth-versus-austerity policy shift means that fiscal policy will be relaxed and austerity goals postponed; a realignment of German politics towards a more pro-integrationist eurozone stance; confirmation of global growth and some glimmer of hope that the eurozone peripheral economies are stabilizing.
Whether these will happen before Greece is forced out of the euro and Europe enters a big economic downturn as a result remains to be seen. But let’s look beyond the Greek/euro debt crisis.
| Global debt |
| Sovereign and private |
 |
| Source: IMF, Independent Strategy |
For here lurks the intractable problem of excessive global leverage in a low-growth, rising cost-of-debt environment.
None of the policy responses, monetary or fiscal, addresses the real global sickness: debt has been accrued to levels that were only sustainable for as long as risk was mispriced and growth was high – boosted by globalization, disinflation and the end of communism.
Global growth is below trend in the weakest economic recovery from recession since the 1930s. The US will join Japan and Europe in the below-trend growth camp next year when its own fiscal austerity starts to bite.
Unless the world spontaneously moves to higher growth through, say, a wave of growth-boosting technology, there are only a few ways out of the dilemma: cut the liabilities – which are the assets of many; inflate massively while rigging bond markets; and/or apply financial oppression in debtor nations – with nefarious knock-on effects for the free movement of capital and trade.
These policy reactions lie further out in time, but they will not go away. They might ultimately lead to deflation or its opposite, hyperinflation. As it became inevitable that sovereign liabilities must be cut, their prices would fall. The economic backdrop could be very deflationary.
Alternatively, massive central bank buying of government debt could be the ATM used to incur monetization, with the aim of generating high-enough inflation to reduce debt in real terms, while holding the cost of borrowing down.
Little clouds
And then there are shocks that float like destructive little clouds outside these economic scenarios – for example war with Iran or North Korea acting aggressively as its state fails. These events can happen at any stage and could tip us towards another economic downturn ahead of time.
I know it sounds depressing, but there are plenty of policy moves that could turn things around, as long as politicians realize the fundamentals and do not just react to events. That is the real worry.