In January, Lucas Papademos, Vice-President of the European Central Bank ECB), strongly suggested that inflation would not fall much below 2% in the eurozone (see the end of this post).  Translated from the language of central bankers, he implied that the risk of deflation in the eurozone was virtually nil.

Now Jean-Claude Trichet, head of the ECB, with reference to the latest eurozone (0%) inflation rate, says that we should disregard the data because a recovery is just around the corner.

Alternatively, we are close to the baseline eurozone view laid out in my January presentation (part of a panel discussion with Mr Papademos).  You can break this down into three specifics.

1. Private sector demand is weak; it’s hard to see who will lead the recovery within the eurozone.  In addition, the demand for European exports has fallen much more than expected, as seen – for example – in the big decline in German Q1 output.
2. The ability of the public sector to offset this decline with discretionary fiscal policy is quite limited, due to balance sheet constraints in some countries (look at the latest credit default swap data from weaker euro sovereigns; CDS primer) and clear policy preferences in others (i.e., how Germany worries about inflation, even when there is none).
3. Banks look troubled across many eurozone countries, and as the real economy surprises on the downside these problems will increase – with presumed implications for government bailout programs and balance sheets (the IMF was quite negative, see Tables 1.3 and 1.4 on pp.28 and 34 respectively, on European banks before the latest round of bad news).  Remember that the European economy depends on banks much more than does the US.

If the world turns around and/or oil prices continue to rebound, the eurozone can presumably avoid deflation.  But it’s hard to see inflation rising any time soon due to the eurozone’s own dynamic.

And if deflation takes root, it is hard to see this proving more tractable or less damaging than deflation in Japan during the 1990s.  Which part of Japan’s lost decade now looks easy to avoid in Europe?

By Simon Johnson

The late Rudi Dornbsuch of MIT had a way of cutting to the chase, preferably in public and with a minister of finance present.  He knew a huge amount about financial crisis, and could distill a lifetime of study and involvement in collapses succinctly: “it always takes longer than you think; but when it happens, it always happens faster than you can imagine.”

The latest credit default swap data for European banks bring Rudi’s perspective to mind – for the United States.  We’ve debated this week what to do about U.S. banks, arguing about which unappealing options are less bad.  In my view, the choice is not “nationalize vs. don’t nationalize,” but rather “keep our current partial nationalization/bottomless pit subsidy system vs. start down the road to reprivatization.”

But, honestly, this entire debate may be overtaken by events. 

Economic developments in East-Central Europe are very bad.  Almost everyone will get IMF loans but, be that as it may, there is a big contraction underway.  Nonperforming loans will increase for the West European banks lending to East-Central Europe or lending to firms that are (or were) exporting.  Prominent European governments will struggle to afford the implied bailouts – remember, back in October these governments made it quite clear they are on the hook if their banks come under pressure.  At the same time, of course, we have a nose dive in property in Ireland, Spain, and the UK.

My point is not that Europe is in big trouble, with no plausible regional rescue mechanisms in place.  This is completely obvious – the debate among prominent Europeans is now whether or not to send distressed eurozone members to the IMF, and on what basis.

Focus on this instead: the European banking and fiscal fiasco is a dagger pointed at the heart of major US banks, which have a great deal of exposure – one way or another – to much of Europe.  Ask any U.S.-based ”global bank”.

Treasury is constructing an elaborate transfer mechanism through which big banks can be kept in business, thanks to the public purse, without the taxpayer acquiring a majority of the common stock.  The contortions required are striking.  But this entire approach is predicated on a rosy stress scenario, which assumes the global economy cannot get much worse, at least in the short run.

It may soon be time to wake up.

In major every crisis you have a choice.  You cannot choose between inaction and action, because ultimately you will be forced to act.  You do not really choose between bailout and no bailout, because very soon you find that all the reasonable options involve some sort of bailout for some people (and not for others).  And, try as you might, there is no way to choose to let your neighbors fail completely – because that failure has such awful consequences for their citizens and, in all likelihood, for your banks, that you finally come across with the money.

But you do have a choice on when to come to help your neighbors and your friends, and you can definitely choose the form of this assistance.  if you come in earlier and in a more systematic fashion, the cost for everyone is lower and the chances of a fast recovery are stronger.

The sensible decision might seems obvious from a distance or in retrospect, but it’s this exact choice that the richer and more stable countries in Western Europe are now struggling with.

Back in October, we argued for a eurozone stabilization fund, as a means of mutual support and – most importantly – as a way to provide liquidity and buy time for euro sovereigns who need to make fiscal adjustments.  Circumstances have changed, of course, but I would like to reiterate the following proposal,

Create a European Stability Fund with at least €2tn of credit lines guaranteed by all Eurozone member nations and potentially other European countries with large financial systems such as Switzerland, Sweden and the UK. This fund should provide alternative financing to member countries in case market rates on their government debt become too high. This will prevent a self-fulfilling cycle of rising interest rates. The fund should be large enough to have credibility; countries could access the fund automatically, but should then adopt a 5-year program for ensuring financial stability, subject to peer review within the Eurozone.

I should also clarify that we are not suggesting that countries leave the eurozone (this would be bad for everyone) or that this is likely (the adverse consequences are sufficiently obvious on all sides).  In fact, my presentation in early January – which has circulated to some effect – very much emphasizes that eurozone fiscal austerity is our baseline expectation.

The German Minister of Finance this week suggested that financial support within Western Europe is on the cards for the first – presumably, his mind is being concentrated by potential developments for Austrian banks.  At the same time, there are strong voices opposed to any kind of bailout, e.g., represented by Charles Wyplosz writing yesterday on VoxEU.org.  Europe should really have had the full moral hazard theology debate back in the fall; better than late than never, but it’s awfully late.

Remember this.  Eventually, you will go to help your neighbors (again, see Iceland for details).  And the longer you delay, the more it will cost, in both monetary and human terms.  And, for those of you still hung up on moral hazard, I can assure you that support provided today will not prevent middle class and poorer people from being hammered hard by the crisis – and I would suggest that they will sort out their rulers at a time and place of their choosing. 

Provide generous support, come in early, and insist on a sensible macroeconomic framework – some fiscal adjustment is almost always needed.  Do not require eurozone countries to go to the IMF.

If you think credit default swap (CDS) spreads are informative with regard to developing pressure points and issues that policymakers should focus on (or will likely spend hectic weekends dealing with), you should look at the latest CDS spreads for European banks.  The Irish story we have already flagged.  I’m also concerned that developments in East-Central Europe are starting to affect the prospects for West European banks, most notably in Austria.

My point is not that collapse is imminent.  Rather, I would suggest that now is the time for preemptive policy action – presumably at the European Union level – to head off these problems.  As we have been arguing since last October, there needs to be an integrated European-wide approach to these problems, including agreement on who receives what kind of financial support and under what circumstances.  The roles of the European Central Bank and the IMF (if any) in this context are in particular need of further explicit elaboration.

It is simply astonishing that, after all we have seen, senior European policymakers remain in substantial denial about the depth of global problems, the way in which these have direct impact on Europe, and value of thinking ahead.

Even if you are convinced that the CDS market represents pure speculative pressure, i.e., unrelated to “fundamentals”, spreads at this level are still a call for action.  In fact, in that case there is no excuse for not putting in place transparent and well-communicated fiscal policies with massive external financial support.  That should scare any speculators away.

Of course, if you believe that the CDS market is completely uninformative, there is nothing to worry about.  And there was, in retrospect, nothing to worry about when the same market pointed to growing dangers for UK mortgage lenders in fall 2007, US banks in 2007-2008, Iceland in fall 2008, and emerging markets right before the IMF started handing out big loans.

One thing you can probably get 99% of economists to agree on is that a global trade war in the middle of a global recession is a bad idea. If every country increases import tariffs, hoping to protect its domestic industry from foreign competition, global trade will fall in all directions, hurting everybody. Put another way, increased tariffs are a negative-sum game.

To date, we haven’t seen much in the way of higher trade barriers during this crisis, although you could argue that some bailouts constitute subsidies favoring local over foreign companies. Instead, however, we are seeing friction over currency valuations. If you want to boost your net exports but don’t want to do the obviously unfriendly thing and increase tariffs, the other option is to devalue your currency: a weaker currency increases the price of imported goods and reduces the price of exported goods, hence reducing imports and increasing exports.

Yesterday, Tim Geithner accused China of “manipulating its currency,” something we’ve heard periodically over the last several years but not in much in the last few months. (Of course, Geithner then said that “a strong dollar is in America’s national interest,” whatever that means.)  Switzerland threatened to intervene on foreign exchange markets to suppress the value of the Swiss franc. And the French finance minister criticized the U.K. for letting the pound depreciate. (Hat tip Macro Man for the last two.)

Theoretically, devaluing your currency is not as bad as import tariffs. If every country tries to devalue its currency at the same time, exchange rates will remain the same; this is a zero-sum game in that sense. It’s a little more complicated, because there are at least two ways of devaluing your currency. One is for the central government to sell its own currency and buy everyone else’s currency on the foreign exchange market. The other, however, is to run an expansionary monetary policy (lower interest rates, more money creation, etc.), which is inflationary. So one possible outcome is that every country runs an expansionary monetary policy, exchange rates remain the same, but commodity prices go up because there is more money floating around. In today’s environment of low or negative inflation expectations, however, that might not be such a terrible thing.

But the other side of competitive currency devaluations is that not all countries are equally well armed. In particular, countries that use the euro cannot devalue their currencies, because they don’t control their monetary policy and they don’t have the scale to intervene significantly on the market for euros. In short, other countries can devalue their currencies at the expense of Eurozone members. This is one of the reasons why, as we (and Martin Feldstein) have warned, the economic crisis will increase tensions within the Eurozone. The New York Times just ran an article on this exact topic:

Germany, France and the Scandinavian countries are mounting billion-dollar stimulus plans and erecting fences to protect their banks. But the peripheral economies are being left to twist in the market winds.

This is a good indicator that fears about the Eurozone are going mainstream.

The spread between Greek government 10-year bonds and the equivalent German government securities rose sharply this week – Greek debt at this maturity now yields 6.0% vs. German debt at 3.1%.  Other weaker eurozone countries appear to be on a similar trajectory (e.g., Irish 10 year government debt is yielding 5.8%) and if you don’t know who the PIIGS are, and why they are in trouble, you should find out.

We also know East-Central Europe (including Turkey) has major debt rollover problems and most of that region is in transit to the IMF, with exact arrival times determined by precise funding needs relative to the usual political desire to keep the party going through at least one more local election.  Put the IMF down for another $100bn in loans over the next six months, and keep the G20 talking about providing the Fund with more resources.

But the big news of the week, with first-order implications for the US and the world, was from the UK where the prospect of further bank nationalization now looms. 

This is a AAA-rated sovereign with its housing market in a nose dive, overextended (and apparently mismanaged) major banks, and a government on its way to guaranteeing all financial liabilities and directing the flow of credit moving forward.  A strategy emerges, but it’s based more on depreciating the pound and surprising people with inflation than on fully-funded bank recapitalization.  Additional fiscal stimulus, increasingly, looks at best irrelevant and – worryingly – perhaps even destabilizing.  The yield on 10-year government bonds is, of course rising – now over 3.5%.

In this context and recognizing that credit ratings are a lagging but not meaningless indicator, Spain’s downgrade from AAA is a significant milestone.  Further European downgrades are in the air.

What do all these situations have in common?  We are repricing the risk (or coming to our senses) on the dangers of lending to a wide range of governments.  And this is not just about emerging markets (East-Central Europe) or industrialized countries that sustained a boom based on euro convergence (the PIIGS), it is potentially about rethinking any government’s obligations.  

What about German debt?  There is no question that Germany will do whatever it takes to maintain a reputation for fiscal prudence.  But problems in the eurozone put pressure on the European Central Bank to loosen its policies (and there are murmurs already about easing repo-rules as credit ratings fall; basically, supporting euro sovereigns during their downward spiral), and this has implications for currency risk. Also, German exports are under severe pressure – their cars, machinery, and similar durables, of course, have a great reputation, but how many of them do you really need to buy this quarter? 

And what about the US?  One view is that US government debt remains the ultimate safe haven, and this is surely true in general terms – particularly in moments of high stress.  But I was struck recently by an excellent presentation by John Campbell (technical paper here).  His point is that while US long bonds go through episodes when they are good hedges against prevalent risks (e.g., now and in the recent past), this is not always true. In particular, if inflation becomes an issue – think 1970s – then long bonds are really quite risky, in both popular and technical meanings of risk.  You may think your bond holdings are a great hedge, but in fact they are a fairly substantial gamble that inflation will not jump upwards.

I also hear people increasingly talking about the limits on sustainable debt in the US (and we will shortly publish a Beginners’ Guide on this).  I’m supportive of the fiscal stimulus, at around the currently proposed level, and I also strongly support the view that cleaning up the banking system properly will add further to our national debt (probably in the region of 10-20% of GDP, when all is said and done).  And I further agree that some form of housing refinance program will help slow foreclosures, and this should further increase the chances that the financial system stabilizes. 

But all of this adds up.  US government debt held by the private sector will probably rise, as a percent of GDP, from around 41% to somewhere above 70%.  This is still manageable, but it should concentrate our minds.  The net effect of our financial fiasco is to push us towards European-style government debt levels, and this obviously presses us further to reform (i.e., spend less on) Social Security and Medicare.  And we really need to make sure we don’t have another fiasco (of any kind) of similar magnitude any time in the near future.

It looks like a bank aggregator for bad assets is pretty much a done deal.  David Axelrod said yesterday we should expect a new approach within a few days, and leading reporters (NYT, Washington Post) have discerned that this is likely to include a “bad bank” into which troubled/toxic assets can be disposed.

We don’t yet know the details, and these matter a great deal (for the taxpayer and for the gradient of the road to recovery) but it’s not too early to think about the global implications, at least in qualitative terms.

The backdrop, of course, is that the international banking environment is very unsettled at present, probably worse than any time since mid-October.  Ireland just had to nationalize its previously most aggressive mortgage lender (i.e., in Irish mortgages) and the UK seems poised to announce a further scheme for helping banks (and probably forcing them to lend, although the British property sector looks highly dubious).  “Bad banks” are in the air, in all senses of the term.

Let’s say the US launches a comprehensive bank recapitalization and balance sheet clean-up scheme, with broad support on Capitol Hill.  This bolsters confidence in the US banking system, causing a rise in equity prices and – most important – a strengthening of debt, both for banks and perhaps for leading nonbank corporates.  Three international consequences seem likely.

First, this move forces the rest of the G7/G10 and the eurozone to do the same, or something very similar.  If we have very strong (and government backed) banks in the US and somewhat more dubious banks anywhere in other industrialized countries, money will flow into the stronger US banks.  Think back to the consequences of the original infectious blanket guarantees in Ireland in October; the effects now would be similar.  You can think of the UK’s upcoming moves either as a smart way to get ahead of this, or as something that will further a destabilizing wave of competitive recapitalizations – the policy is good, but doing it without coordination across countries can trigger Iceland-type situations.

Second, if all major economies need to back the balance sheets of their banks, then we have converted our myriad banking sector problems into a single (per country) fiscal issue.  Who has sufficient resources to fully back their banks?  This obviously depends on (a) initial government debt, (b) size of banks (and their problem loans, global and local), and (c) underlying budget deficit.  Ireland and Greece will be in the line of fire, but other weaker eurozone countries will also face renewed pressure.  Officials are currently (slowly) trying to work through this predictive analysis, and there is some sketchy thinking about preemptive preparations, but events are moving too fast - and the international policy community again can’t keep up. 

Third, in some countries – particularly emerging markets but also perhaps some richer countries – the foreign exchange exposure of banks will matter.  Here the issue will be whether the government has enough reserves to back (or buy out) these liabilities; the problems of Russia since September foreshadow this for a wide range of countries.  The absolute scale of reserves does not matter as much as whether they fully cover bank debt in foreign currency.  Most emerging markets face significant difficulties and need some form of external support in this scenario, particularly as both commodity and manufactured exports from these countries will continue to fall.

If, by great and fortuitous coincidence, the US and global recession is already at its deepest – as some in the private sector now hold – then we face a tough situation but the difficulties are manageable. However, our baseline view remains that the real economy is not yet stabilized, and hence we will see worse outcomes in Q1 and Q2 of 2009 than currently expected by the consensus.  Such outcomes are not yet reflected in asset prices, and the problems for banks – and the implications for fiscal sustainability – around the world will mount.

Financial support for distressed countries within the eurozone, from the G7, and across the G20 will help; the scale may be beyond what the IMF can readily handle by itself.  But this is a very big global fiscal problem, and the appetite for large-scale official rescue financing in the face of these problems remains uneven.

According to Bloomberg (citing the RTE website), the Irish Prime Minister said in Toyko today that Ireland may need to call in the IMF if economic conditions continue to deteriorate.  According to RTE (Ireland’s public broadcaster), correcting their earlier story, he said no such thing, at least in public.

The broader issue, of course, is that Ireland is not alone in facing economic difficulties – the risk of default, potential debt rollover issues, and credit ratings are likely to move together for a range of weaker countries in Europe’s eurozone.  But the presumption has been that the IMF would not get involved in eurozone countries.  Any change in this view would throw us back to thinking in terms of the 1970s (when the IMF lent to the UK and to Italy) or the 1930s (when IMF loans could have helped, but of course were not available). Unless you really intend to bring in the IMF for loan discussions, I would suggest it is a bad idea to use those three letters in any conversation, public or private.

Remember that in early October Ireland destabilized the eurozone by suddenly offering blanket bank deposit guarantees.  The apparent lack of policy coordination within the eurozone continues to be worrying.  These countries really need to start working together more closely.

Relatedly and consistent with my presentation last week, Greece’s sovereign credit rating from S&P was lowered today.

I’ve had a chance, over the past 10 days, to debate the details of what’s next for the macroeconomy with leading policymakers in both the eurozone/EU and India.  I’m struck by some similarities.  In both places, there is little or no concern that inflation will rebound any time soon.  At least for people based in Delhi, there is as a result confidence that conventional policy can now act aggressively to cushion the blows coming from the global economy.  In the eurozone, all eyes are on monetary policy and the same is true for India – both places have almost the exact debate about whether fiscal policy can do much more than it is already doing, given that government debt levels are already on the high side.

The discordant note comes from people based in Mumbai.  They feel that Delhi does not fully understand that the real economy is already in bad shape.  Sectors such as real estate and autos are hurting badly.  Small businesses, in particular, seems to be bearing the brunt of the blow.  The banking picture seems more murky, but is surely not good.  And of course the Satyam accounting scandal could not come at a worse time.

Overall, my strong impression is that growth forecasts will need to be marked down for India and the eurozone.  Both will likely cut interest rates further quite soon (and have space for additional cuts), but we should not expect much more from the fiscal side in either place.  They will both start to look beyond standard macro policies  - although India may make progress on this front sooner.

I also heard strong and reassuring opposition to protectionism – although, I must say the case against any kind of trade restriction comes through more clearly in India than in the eurozone.

One leading anti-recession idea for the moment is a global fiscal stimulus amounting to 2% of the planet’s GDP.  The precise math behind this calculation is still forthcoming, but it obviously assumes a big stimulus in the US and also needs to include a pretty big fiscal expansion in Europe.  (Emerging markets will barely be able to make a contribution that registers on the global scale.)

What are the likely prospects for a major eurozone fiscal stimulus?  My presentation yesterday on this question is here.  The main points are:

The pressure is really on euro sovereigns with relatively weak fiscal positions.  This may not seem fair, in the sense that the crisis started far away (in some sense), but that is how crises work.

Whether or not the global recession is bad, countries like Greece and Italy (and a set of countries now known in the markets by the unfortunate acronym of PIIGS) are being pushed towards urgent fiscal austerity, i.e., the opposite of expansion.

They could, of course, get some sort of help from stronger eurozone members, for example in the form of much lower interest rates.  But this does not seem to be immediately in the cards.

The reaction that one hears from senior European officials and richer eurozone countries is that Greece (and Italy and others) should deal with their fiscal problems.  There is very little sympathy and even less bailout money.  This is in striking contrast with the attitude – and willingness to open pocket books – shown towards East-Central Europe, which is currently being treated more as a set of innocent bystanders.

It is hard to see how to pull a large global fiscal stimulus out of the hat.  Pursuing expansionary monetary policy in the US and elsewhere is much more likely to have first order effects on industrial countries and, through them, on the world’s economy.

Asking for a major push on fiscal policy is not a bad thing in most contexts.  But it does encourage free riding, i.e., you go build a lot of roads and bridges and I’ll recover through exporting vehicles and machinery to you – which appears to be the current German strategy.

Getting the G7 or G20 to really coordinate on fiscal stimulus is rather like OPEC trying to coordinate oil production cuts.  Both are really hard to do in a severe downturn, particularly as budget pressures mount.

Aside: my presentation was part of a panel discussion on the euro at the American Economic Association conferenc in San Francisco. ECB Vice President Lucas Papademos was also on the panel, and told the press afterwards: (I’m taking the quotes as reported by Citigroup this morning, to illustrate what the market is focussing on)…

“inflation will not be allowed to fall significantly below 2% for a protracted period of time, over the medium term, which we do not expect on the basis of our present analysis”. He added, that the ECB “will do what is necessary, in terms of the timing and the size (of interest policy action) to ensure price stability”. However, he added that“cutting interest rates to very low levels must be judged with special care because of the long-term implications for price stability”

I had a heated discussion about our new baseline scenario yesterday with some angry European politicians.  Specifically, the most agitated were from the eurozone and they find our assessment of the risks and likely futures in that region to be unacceptable.  In their view, this is an American problem and that is where the impact will be felt.

While we can surely agree that regulatory failings (and more) in the US are at the epicenter of the crisis, we are facing a global problem precisely because other countries’ banks are involved either directly (because they bought a lot of claims on assets that went bad; see your domestic regulators for details on how that happened) or indirectly (because they finance trade with the US/Europe, and this is now slowly markedly).  And we should no longer think of this as a supply side problem in the credit market; increasingly, consumers and firms around the world want to spend (and borrow) less. 

And here’s the point about Europe – perhaps the reason there is so much anger and even some denial.  European governments have a lot of debt – in the case of some weaker eurozone countries, this stands at over 90% of GDP.  Fiscal policy did not prepare for a financial sector problem of the current magnitude and the way in which bank recapitalization was handled recently has only exacerbated the underlying solvency issues.  As a result, there is very little room for a meaningful fiscal stimulus; if governments attempt even more, there will be issues of confidence.  Quite probably there will be pressure for austerity even at current debt levels.

The Europeans really need to get organized to provide more support to weaker EU countries and the weakest eurozone members.  Try to deliver this message at every opportunity.  If you get shouted down, keep at it.