I now believe that system risk in the euro zone is being grossly under discounted.
The implied assumption for the major currency regions is that during a slowdown the automatic fiscal stabilizers- falling government ‘revenues’ and increased transfer payments- will kick in to increase deficit spending, and thereby add the income and savings to catch the fall and support the next expansion.
This has always been the case, and as we all know, the most accurate forecasts are the ones that assume it’s not different this time.
But the relatively new and evolving euro zone arrangements are qualitatively different.
Spending by euro zone national governments is now market constrained in Greece, Ireland, and Portugal, with the rest looking like they aren’t far away from those same market constraints.
In a slow down, this means as tax revenues fall, markets may not permit government spending to rise, unless the ECB immediately funds all the national governments as well as the banks. Just as we see happening to the US states.
Not that the ECB won’t eventually do that, but that they are unlikely to proactively do it.
In other words, it will all have to get bad enough for the ECB to write the check that only they can write.
This means the euro zone is now flying without a net.
And the potential drop in aggregate demand is far higher than markets are discounting.
And that kind of catastrophic collapse in aggregate demand in the euro zone will have immediate catastrophic global impact.
And the fiscal discussions going on in Japan and elsewhere tell me there is a clear risk even the operationally unconstrained nations will be very reluctant to immediately and proactively move towards fiscal expansion.
Instead, they will let it all deteriorate until their automatic fiscal stabilizers to kick in.
Much like what happened with the 2008 financial crisis, where the lack of a will to engage in an immediate fiscal response let that financial crisis spill over into the real economy.
Can all this be avoided? Yes, and the remedy is both simple, immediate, and would quickly lead to unprecedented global prosperity.
All the euro zone has to do is have the ECB write the check, and announce immediate and annual distributions of 10% of GDP to member nations to pay down their outstanding debts, and at the same time impose national deficit ceilings sufficiently high to promote desired levels of aggregate demand. And the penalty for non compliance would be the withdrawal of ECB support. This would remove credit concerns, without increasing government spending, so there would be no inflationary impact.
And all the rest of the world has to do is recognize that federal taxes function to regulate aggregate demand, and not to fund expenditures per se. And then set taxation and/or government spending at levels that sustain desired aggregate demand.
They need to know the question is not whether longer term the budget deficit is sustainable- as it’s always nominally sustainable- but instead worry about sustaining aggregate demand at desired levels, both long term and short term.
But, unfortunately, I see the odds of a catastrophic collapse in aggregate demand as far higher than the odds of an awakening to a global understanding of actual monetary operations.