So Spain has got the downgrade and now folks have worked themselves into a lather.
The question remains, as it has for the last 18 months: what did you think was going to happen? And the truth is, it's going to happen again.
This is not happening, primarily, because Southern European countries refuse to cut spending. Many of the countries may need to cut spending and regulation but these crises are happening because Southern European countries aren't growing and when you don't grow, your deficit blows up. Recessions do that (Mr. Ryan, take note).
Europe has a banking crisis from under capitalized banks who hold rapidly depreciating assets (in the form of these government bonds) so there is a constant danger of insolvency and runs on them. It's not so different from the US banks in 2008 in that way. But, rather than directly recapitalize the banks a la TARP, the ECB is giving the banks cheap loans to keep themselves running. They are taking the money and calling in every loan they can to reduce their leverage. So it has set the stage for an awful credit crunch which undermines growth.
Europe also has a direct growth crisis/fiscal crisis (depending how you are inclined to describe it).
Southern Europe has had low productivity growth and Northern Europe high productivity growth. Normally, a country getting into trouble like that of Southern Europe would have a devaluation and use exports as their growth strategy. But locked in at the high exchange rate, S. Europe can't do that. Without growth and with the credit contraction from the banks trying to reduce their leverage because of the banking crisis, these countries' deficits are awful and likely to get worse. Even the most savage austerity really isn't going to fix this problem.
We know a lot about how very different economies can be held together in a monetary union. Choose one: 1) The rich guys subsidize the poor guys permanently. 2) A massive exodus of people goes from the poor guys to the rich guys or 3) the poor guys experience massive, extended unemployment and stagnation as they try to grind down everyone's wages and do the equivalent of a devaluation.
Sometimes, as when East Germany joined West Germany at an over-valued exchange rate, they can have all three and have it last for decades.
The problem is, each of them seems impossible but the hard part is coming up with an alternative. Some might add a 4) ECB prints money to monetize the debt and creates inflation but I tend to lump that into the permanent subsidy hypothesis. Regardless, it also seems impossible.
What this means for investors and spectators is the following prediction:
Europe will struggle and find a way to adopt an approach they describe as temporary/one-time/final/emergency that calms the market about Spain. It will involve something vaguely financial market sounding and have some acronym--XLRPTO--but will be some explicit or implicit subsidy--loan guarantees, extra liquidity from the ECB, or anything of that sort would count in the style. It will come with a lecture from the stronger part of Europe about how Spain needs to get their house in order and cut spending and Spain will probably start such a program.
Within three months, the grim iron logic of no growth will blow the deficit up in some other country in Southern Europe--Portugal, Italy, maybe Greece again--and then spreads will rise again and they will do the same dance. Then within three months of recession and no growth, deteriorating finances in another country will lead to another scare and the same thing. Then within three months ...
It will be the most painful version of the permanent subsidy solution that could possible exist. It will hold things together for as long as the rich countries remain willing to foot the bill (or implictly foot the bill in the case of Euro guarantees).
I dread this outcome. I really don't want it to happen. But, please, someone help me understand why the argument is wrong.
