Beware of Falling Masonry–a comment on today’s Economist’s article…

Beware of falling masonry, an Economist article neatly summarises some of the critical aspects of the Euro crisis: the encroachment of the crisis on the Euro core; the net foreign liabilities of the weaker Euro members; the exposed position of Euro banks dependent on wholesale credit markets; the gathering run on banks by both retail and institutional investors; deleveraging by the Euro financial system; the impact on emerging market borrowers of financial system retrenchment; fiscal austerity and near certain recession, and the compounded risks of them all.  

Where it may be unwittingly over optimistic is the belief that ECB buying of Euro debt could avert disaster.  Unfortunately the disaster is a real economic, at heart, and not a monetary phenomenon, and monetary support can only provide time, if applied early, which it has not.  There is also reason to suppose that monetisation in an overarching excessive debt environment may create mismatches between supply and real demand, that could exacerbate and accentuate financial system risks: note the large increase in inventories in the US that may have been occasioned by confidence created by rising asset prices due to central bank debt monetisation.   

The idea of a “European Redemption Pact” is also naive in the sense that transferring debt to a vehicle to be paid off over a 25 year period ignores one important reality: repayment of debt impacts the GDP base, preventing an economy from growing and forever exposing it to economic risk.   Forcing the Eurozone to repay debt (as opposed to merely refinancing) will forever impinge on the growth of the Eurozone. 

The only way debt can be made manageable is to either default or to allow nominal GDP growth to reduce the burden of debt.  But, once you move beyond the point where you can no longer reduce expenditure and finance your own deficits, without serious and adverse consequences, you no longer have the option of letting nominal GDP growth lessen your burden. 

In many economies nominal GDP growth is in the mid to single digits, but debt financing costs and/or budget deficits prevent nominal GDP growth from reducing debt to GDP ratios.  

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