So far, rising spreads on credit default swaps have accurately predicted what sectors of the global economy would run into trouble next. The sharp rise in spreads on emerging market countries’ debt is old news. But recently, CDS spreads have been rising for countries that are part not only of the EU but of the Eurozone, such as Greece, Portugal, Ireland, and even Italy. The basic fear is that these countries may not be big enough to bail out their banks, so risk has spilled from the private sector into the private sector. The need for flexibility in monetary policy (currently ceded to the European Central Bank), the pain of a severe recession, and the increase in nationalist politics that often accompanies economic misery could lead one or more countries to abandon the euro. The costs of abandoning the euro would be very high, but it is a scenario that has changed from unthinkable to merely unlikely.
There are steps that policy makers can take now to reduce the threats of national defaults and of a fragmentation of the Eurozone. We discuss the situation and our policy proposals in a new op-ed in The Guardian.