This Disastrous 'Debt Crisis' Myth

The real risk of a new recession in the US and Europe comes not from debt, but by strangling growth with a fiscal tourniquet

The prevailing understanding of economic troubles in the US and Europe, the world's two largest economies, is misunderstood in a number of ways. First, imagine that you are driving a car down a road packed with snow and ice, and you are worried about an accident. At the same time, you are ignoring the fact that you are about to run out of gasoline, leaving you stranded and freezing in the middle of nowhere.

Such have been the main reactions to last week's extreme volatility in financial markets: there has been much more fear of financial crisis than the slow strangulation that poses the greater risk. Investors' panic attack subsided noticeably after the European Central Bank's (ECB's) decision to reverse its prior stance and purchase some EUR22bn of Italian and Spanish bonds, which was successful. It drove down interest rates on these bonds by more than a full percentage point, to 5%, and eliminated - for now, at least - the most immediate threat of an acute financial crisis: the one that emanated from the fear that markets would drive up interest rates on these bonds to a dangerous level.

The European authorities also took some action to stem the immediate crisis of the European banks, which is, of course, related to the sovereign debt problems: France, Belgium, Italy and Spain banned short-selling of the stocks of financial institutions. According to some press reports, speculators were shorting these stocks partly because the ECB was committed to keeping a floor under the euro, leaving the bank stocks as a "soft target". The ban on short-selling seems also to have helped, temporarily anyway.

The most dangerous myth, and one repeated daily in much of the major media, is that these troubles on both sides of the Atlantic are a result of a "debt crisis", and can only be resolved through fiscal tightening.

But there is still a lot of fear that we are close to a repeat of 2008-2009, when the US fell into a deep recession and much of the world economy was dragged down with it. For the US, this is not all that likely: the great recession was caused by the bursting of an $8tn housing bubble, and there is no such bubble now available to burst. The recession before that (2001) was also caused by the bursting of a big asset bubble - in the stock market, which is not currently overvalued. The three recessions before were brought on by the Federal Reserve deliberately raising interest rates in order to slow the economy; but the Fed last week committed itself to keeping interest rates "very low" for two more years.

Of course, if unemployment remains at 9.1% or worsens, it will feel like a recession to most Americans even if we don't have negative growth. But the probability of an actual recession has been exaggerated, and the chance of a recession like the last one is very remote.

In Europe, where macroeconomic policy has been more rightwing, recession is more likely. Portugal and Greece are already in recession, and others are not far away. In return for the ECB's buying up Italian bonds, the European authorities extracted a promise from the Berlusconi government to close a 3.9% of GDP budget gap by 2013. This could easily push Italy's $2tn economy into recession. The latest GDP numbers for Europe's second quarter arrived this week, and they look dismal: just 0.2% growth in the second quarter in the eurozone, the worst for two years. Germany, Europe's largest economy, was practically stalled at 0.1%, and France, the second largest, came in at zero.

The most dangerous myth, and one repeated daily in much of the major media, is that these troubles on both sides of the Atlantic are a result of a "debt crisis", and can only be resolved through fiscal tightening. The United States is not facing any public debt crisis at all, with interest payments on the debt at just 1.4% of GDP. Some eurozone countries do have a "debt crisis" - for example, Greece. But this is only because the European authorities have failed to take the necessary steps to resolve it, and have, instead, made it worse by shrinking the economy. In other words, there is no legitimate economic reason for a sovereign debt burden - even an unsustainable one - to result in years of economic stagnation and high unemployment. If the debt needs to be restructured because it is not payable, as in Greece, then that should be done as quickly as possible and with enough debt cancellation to make the resulting debt burden sustainable - as Argentina did with its successful default in 2001.

The eurozone is, of course, handicapped by the lack of a unitary fiscal authority, and many were disappointed that this week's meeting of French President Nicolas Sarkozy and German Chancellor Angela Merkel did not move toward the use of eurobonds. Much worse was their pledge to push for a Europe-wide balanced-budget amendment, starting in their own countries. This is ridiculous and - to the extent that it is not mere posturing - would only be another indicator of how far Europe's leaders are from reality-based economic policy.

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