Did the European Deal Just Collapse?

Last Updated Nov 1, 2011 2:54 AM EDT

Last week's attempt to rescue the European financial system has not calmed financial markets. The attempt, which involved creating a bailout fund to purchase the assets of troubled countries, was imprecise in terms of how the bailout fund would be financed. This, along with other problems such as the way in which the Greek debt would be written down led to a lack of faith that the plan would work. Tim Duy explains (Tim's post is well worth reading in full):
Did The European Deal Just Collapse?, by Tim Duy: To be sure, I have been bearish on Europe. From last week:
I remain something of a Euroskeptic at this point. At best, I think the Europeans will be kicking the can down the road for a few months.
It turns out a "few months" might have been wildly optimistic. It was quickly evident that bond markets didn't show the same enthusiasm equity markets expressed for the supposed deal. That was huge red flag. The second red flag was the Bank of Spain announcing a stagnant 3Q GDP. ... the Bank of Spain blamed missing deficit reduction targets on fiscal austerity and then suggests additional fiscal austerity as the solution. And as all nations in the Eurozone increasingly pursue fiscal austerity, we can only expect the nascent European recession to deepen. Finally, a lynchpin in the European debt deal - Greece - apparently isn't ready to abide by the terms of that deal. ...

Bottom Line: Last's week European Summit accomplished far less than even the reduced expectations going into last week. The cracks began appearing before the ink was dry. More worrisome is that the Greek leadership didn't even believe they were on board in the first place. Simply put, the world economy is no less fragile than it was a week ago. And in that fragility still lies the recession risk for a still struggling US economy.

With last week's European rescue plan falling apart, with Italy looking shakier and shakier every day, and with the problems in other European countries such as Spain continuing to worsen, what will it take for the European financial problems to stabilize?

A big problem throughout the crisis has been the refusal of the European Central Bank to serve as a lender of last resort. As Brad DeLong explains, "The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has 'only one needle on [its] compass, and that is inflation. ... Perhaps the most astonishing thing about the ECB's monochromatic price-stability mission and utter disregard for financial stability â€" much less for the welfare of the workers and businesses that make up the economy â€" is its radical departure from the central-banking tradition.'"

Presently, we are in a "vicious circle of self-reinforcing austerity." Countries get into trouble and debts pile up. In an attempt to reduce those debts, the countries cut back on government expenditures, i.e. they adopt austerity policies. However, the cuts in government spending make the economy grow even slower, that makes it even harder to pay the bills, further cuts are required which slows the economy more, and so on as the economies spiral downward.

To stop the downward spiral, the ECB needs lend freely to troubled countries in its capacity of lender of last resort. It also needs to adopt a policy of quantitative easing, i.e. to purchase the securities of troubled institutions. Unless and until it does, the "vicious circle of self-reinforcing austerity" will likely continue.