Global financial system is entering dangerous waters again, warns Lehman crisis guru

The perennial locus of trouble is Europe’s half-built monetary union, where the European Central Bank’s bond-buying spree has mopped up debt issuance by Club Med (and France) as if there was no tomorrow, and tomorrow has now arrived.

“Could Italy get bad fast? Yes, definitely,” he said.

Italian 10-year bond yields have tripled this year to 3%. Risk spreads soared to 200 basis points, higher than they were when Mario Draghi was recruited by political elites to save the country.

Professor Tooze said the ECB had no credible mechanism to defend southern European states when QE ended.

“They talk about a spread-management tool and tell us they have a miracle solution, but the markets don’t believe it,” he said.

Such an instrument, if it ever emerges, goes beyond anything that is plausibly called monetary policy. It looks like a naked rescue of insolvent sovereign states in violation of EU treaty law and invites a challenge in the German Constitutional Court. This is anathema to northern hawks alarmed by the ECB’s slide into fiscal dominance.

“We all know that if there was a legal way to control yields, they would have used it by now. So it’s just a sleight of hand,” he said. The ECB can “distort” the reinvestment of its existing portfolio towards vulnerable countries, but this is a symbolic gesture.

Another spasm of Club Med debt angst comes as market vigilantes test the ECB’s ability to act. The exchange rate will be strained: Amundi, the 2 trillion euro European investment giant, has said it expects the euro to reach parity with the dollar this year.

Professor Tooze does not think the euro will disintegrate. European leaders cannot let this happen, but neither will they solve the inconsistency of an orphan monetary union without a fiscal union. “The whole Eurozone has been in suspended disbelief for years. It should explode but it never does because somehow they find ways to improvise,” said he declared.

This does not rule out a crisis along the way, and Italy is the candidate that stands out because it has an incendiary policy as well as zero trend growth and a debt ratio of 151% of GDP. The unelected Mr. Draghi will soon be gone and the Eurosceptic far right is leading in the polls. The markets will also test it.

The silver lining is that inflation does wonders for debt dynamics. It erodes the real burden of borrowings inherited from the past through the denominator effect. People across the West should stop worrying about the CPI horror story and remember that bondholders – with broad shoulders – are paying the main tab of the pandemic.

“Two or three years of inflation above 5% is good: it burns up debt. But you have to protect the vulnerable against real income losses. It’s a problem of poverty, and there are policies to fix it. “, did he declare.

The UK certainly does not. The government is implementing the fastest budget cut in the developed world, apparently convinced that public debt is approaching a critical level, or believing that medium-sized open economies with large trade deficits cannot take risks.

“It’s a repeat of the panic of 2010, but without the rhetoric. I don’t see how they’re going to build a workers’ coalition like this,” he said.

Arguments over austerity were never settled. There are compelling arguments that fiscal tightening at the wrong time and at the wrong therapeutic dose is inherently counterproductive. It doesn’t reduce the debt ratio any more than it otherwise would, leaving aside the lost economic growth and social misery caused along the way.

America is doing its own variation of easing austerity, abruptly going from sky-high deficits to negative fiscal stimulus, but not because the White House chose to. Joe Biden can’t get his spending through Congress.


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Don F. Davis