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Monday, January 02, 2012

Question #8 for 2012: Europe and the Euro

by Calculated Risk on 1/02/2012 09:40:00 PM

Earlier I posted some questions for next year: Ten Economic Questions for 2012. I'll try to add some thoughts, and maybe some predictions for each question.

I've been stuck on #8, probably because I'm suffering from European crisis fatigue. It is very disturbing when a key policymaker like German Finance Minister Wolfgang Schaeuble says "This is not a euro crisis, it is a debt crisis in some euro states". Not only is that incorrect, but it is a reminder that the current policy is all stick and no carrot. Where is the growth agenda? The current path of endless austerity, slow wage deflation, and high unemployment in several countries seems politically unsustainable. Much of Europe is probably already in recession, and it could get much worse.

It seems only a serious event, what many analysts are calling a "Lehman moment", will shock policymakers into more effective action. But maybe that is too pessimistic. There has been some discussion of a "roadmap" for the issuance of eurobonds (this will probably be discussed on January 9th). And apparently a growth agenda will be discussed at the next summit meeting on January 30th. That sounds like small carrots. A little more inflation would help with adjustments too, but no policymaker will say that openly.

A key short term issue is the haircuts for private creditors of Greek debt. This is expected to be resolved very soon. No agreement probably means default, and possibly an exit from the euro. So I expect an agreement to be reached at the last minute.

And all year there will be significant bond auctions for Italy, Spain, Belgium and France. More market stress is guaranteed.

Here is what I wrote a year ago:

I think:
• The euro will somehow survive another year without losing any countries.
• The next blowup will be in the first couple of months. ...
• There are two main channels that could impact the U.S. economy: trade, and financial spillover / credit tightening. The impact on trade will probably be minimal, even if the euro falls sharply against the dollar (a small percentage of U.S. GDP is from exports to Europe). The financial channel is much more of an unknown, and there is significant downside risk.
If the Greek debt deal is reached, and some sort of carrot (growth agenda, eurobond roadmap) is offered to the suffering countries, maybe Europe and the euro will make it through 2012. So once again my guess is the euro will survive another year without losing any countries (Assuming a Greek debt deal). There will be plenty of blowups along the way, but I think the impact on the US economy will be fairly minimal.

There is a strong commitment by policymakers to the euro, but at some point, without some perceived carrots, the political consensus will eventually disintegrate, and Europe will come apart. Then the impact on the US would be significant.

Question #10 for 2012: Monetary Policy
Question #9 for 2012: Inflation