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European financial crisis: Apocalypse soon?

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The OECD's new assessment of the macro-economic situation makes for pretty grim reading. And their forecast of very sluggish global growth (just 1.6 per cent for the OECD area in 2012) is based on an increasingly incredible view that the Eurozone will "muddle through" and experience only a mild recession.

They do not seem to have convinced even themselves that this is really the most likely outcome.

They make some fairly heroic assumptions to get to their weak growth scenario. Noting that the legislatively mandated cuts to government spending in the U.S. amounting to 2 per cent of GDP in 2012 would tip that country into recession, they assume that fiscal tightening will be a much more limited 0.5 per cent of GDP. They assume further interest rate cuts by the ECB, and continued very loose monetary policy in the U.S., the U.K., Japan and elsewhere.

While nothing really, really bad is forecast to happen in the Eurozone in the central projection, in Box 1.5 (p.49) they set out a scenario in which the spread of "contagion" to Italy and beyond leads to a financial crisis and a collapse of real business investment and consumer confidence roughly similar to that experienced after the fall of Lehman Brothers in the Fall of 2008, with the impacts on the U.S. being at least as great as in the Eurozone itself. The OECD growth rate would fall by 2 per cent of GDP in 2012 compared to the 1.6 per cent baseline. And that relapse into recession scenario itself assumes that no country leaves the Eurozone.

There is an extended discussion -- from p.39 -- on the crisis mechanisms that would come into play in a deepening of the Euro crisis. Sovereign debt defaults would likely lead to an international banking crisis as well as a collapse of business and consumer confidence. It is noted that very little is known about non-bank holders of European sovereign debt and, crucially, credit default swaps on that debt. It is extraordinary that, three years after the collapse of much of the U.S. shadow banking system, very little is known about where the Eurozone default risks are concentrated. (e.g. at p.47: "Little is known about the exposure of U.S. and Japanese non-bank financial institutions to the euro area countries."

The OECD are pretty weak on solutions. They call for easing of fiscal restraint in the U.S. (from a currently anticipated level of 2 per cent of GDP), but say that in the Euro area "planned consolidation must be implemented to regain confidence." (p.36.) It is interesting to note (See Table 1.4) that if the Euro area is taken as a whole, it is in much better fiscal shape than the U.S. But the markets must, apparently, be appeased regardless of the facts on the ground.

In a worse case scenario where countries left the euro, Armageddon:

"If everything came to a head, with governments and banking systems under extreme pressure in some or all of the vulnerable countries, the political fall-out would be dramatic and pressures for euro area exit could be intense. The establishment and likely large exchange rates changes of the new national currencies could imply large losses for debt and asset holders, including banks that could become insolvent. Such turbulence in Europe, with the massive wealth destruction, bankruptcies and a collapse in confidence in European integration and co-operation, would most likely result in a deep depression in both the existing and remaining euro area countries as well as in the world economy." (p.53.)

An upside scenario, by contrast, would require euro area guarantees on all sovereign debt, backed by ample resources, and most likely involving the European Central Bank. Exactly what seems to still be a political non-starter for Germany.

This article was first posted on The Progressive Economics Forum.

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