Aseries of unusual events occurred late last week. On Thursday, the European Central Bank (ECB) resumed its emergency debt purchase programme and bought Irish and Portuguese securities. This it did after a pause of 18 weeks. Soon after, the world’s equity markets tumbled, wiping off $2.5 trillion of investors money. Just after that massive slide, the credit rating agency Standard and Poor’s (S&P) cut the rating of the US from AAA to AA+, the first time it has done so since 1941.
One could say the three events were independent. They were not. When ECB began buying securities again, it sent a signal: it did not purchase Spanish and Italian securities. The stampede in the world’s markets, if not linked to this step, certainly occurred very close to it. A day later, Spanish and Italian bond yields rose to their highest levels since the euro was introduced in 1999. This happened on the same day when the country operating the world’s reserve currency ceased to be the highest rated sovereign.
While the driving force behind these events is well known—the?unsustainable debt levels in the entire Western world and the rising chances of another recession—they are also important from a psychological perspective. When seen together, the picture is ugly.
Does it correspond well with reality? Unfortunately, it does. One part of the problem is that Europe simply does not have the kind of money required to bail out all economies that need its help. The European Financial Stability Facility—created expressly to help tottering economies—has a war chest of only €440 billion. If one includes the potential costs of Italian and Spanish bailouts, the money needed would be close to €700 billion. That gap in what is needed and what is available rocked the markets on Friday.
In Europe and the US, the problem is political. In both places, the gulf between what needs to be done and what is being done is large. In the US, the S&P downgrade was the result of what politicians agreed to save—$2.1 trillion in 10 years—and what the markets expected—closer to $4 trillion. In Europe, getting Greece to agree to austerity led to a political crisis in Athens. Italy has not even awoken to the magnitude of the problem it needs to address. Both the US and Europe have pushed themselves into a corner: one cannot spur growth by cutting spending, but neither can spend anymore. The coming days could possibly see another crisis of the kind seen in 2008.
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