Is Europe On The Verge Of Another Great Depression – Or A Great Inflation?

By Simon Johnson

The news from Europe, particularly from within the eurozone, seems all bad.  Interest rates on Italian government debt continue to rise.  Attempts to put together a "rescue package" at the pan-European level repeatedly fall behind events.  And the lack of leadership from Germany and France is palpable – where is the vision or the clarity of thought we would have had from Charles de Gaulle or Konrad Adenauer?

In addition, the pessimists argue, because the troubled countries are locked into the euro, there are no good options.  Gentle or even dramatic depreciation of the exchange rate for Greece or Portugal or Italy is not in the cards.  As a result, it is hard to lower real wages so as to restore competitiveness and boost trade.  This means that the debt burdens for these countries are likely to seem insurmountable for a long time.  Hence there will likely be default and resulting global financial chaos.

According to the September 2011 edition of the IMF's Fiscal Monitor, 44.4 percent of Italian general government debt is held by nonresidents, i.e., presumably foreigners (Statistical Table 9).  The equivalent number for Greece is 57.4 percent, while for Portugal it is 60.5 percent.  And if you want to get really negative and think the problems could spread from Italy to France, keep in mind that 62.5 percent of French government debt is held by nonresidents.  If Europe has a serious meltdown of sovereign debt values, there is no way that the problems will be confined just to that continent.

All of this is a serious possibility – and the lack of understanding at top European levels is a serious concern.  No one has listened to the warnings of the past three years.  Almost all the time since the collapse of Lehman Brothers has been wasted, in the sense that nothing was done to put government finances on a more sustainable footing.

But perhaps the pendulum of sentiment has swung too far, for one simple and perhaps not very comfortable reason.

There is no way to have just a little debt restructuring for Italy.  If Italian debt involves serious credit risk – i.e., a nonzero probability of default – then all sovereign debt in Europe will need to be repriced, downwards.  There is a notion that Germany will remain a safe haven, but even that is far from clear.  According to the IMF, gross government debt in Germany will be 82.6 percent of GDP at the end of this year (Statistical Table 7 of the IMF's Fiscal Monitor; the net government debt number for 2011, in Statistical Table 8, is 57.2 percent).  Reports of German fiscal prudence have been greatly exaggerated.

There is no way that the German policymakers or the German public will do well in the event of a major sovereign credit disaster.  Credit would tighten across the board.  German exports would plummet.  The famed German social safety net would come under great pressure.  If Germany had to call in the International Monetary Fund for advice, even informally and behind the scenes, how would that feel?

And they have an alternative – allow the European Central Bank to provide "liquidity" support across the board to the troubled governments.

There are many things wrong with this policy – and it is exactly the kind of moral hazard-reinforcing measure that has brought us to the current overindebted moment.  None of us should be happy that Europe – and the world – has reached this point.

Among others, the bankers who bet big on moral hazard – i.e., massive government-backed bailouts – are about to win again.  Perhaps the Europeans will be tougher on executives, boards, and shareholders than the Obama administration was in early 2009, but most likely all the truly rich and powerful will do very well.

But if your choice is global calamity or – effectively – the printing of money, which would you choose?

The European Central Bank has established a great deal of credibility with regard to keeping inflation at or close to 2 percent.  It could probably offer a great deal of additional support – through creating money – without immediately causing inflation.  And if the ECB is providing a complete backstop to Italian government debt, the panic phase would be over.

None of this is a lasting solution, of course.  Europe needs a proper fiscal center – much as the United States needed in 1787 and got under Alexander Hamilton's policies from 1789.  Hamilton remains a controversial figure in US history but when he took over the US was in default and the credit system was almost completely broken.  Some centralized tax revenue and control over fiscal deficits

Mr. Berlusconi stood in the way of all this.  There is no way that the other Europeans would trust him to tighten Italian fiscal policy.  But if he is really gone from power – and we should believe that only when we see it – there is now time and space for Italy to stabilize and, with the right help, find its way back to growth.

Of course, if the ECB provides unconditional financial support to Italian or other politicians who refuse to bring their deficits under control, then we are heading for another Great Inflation.

An edited version of this post appeared this morning on the NYT.com's Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.