In Europe, a tussle plays out between market certainty and political reality
In the 1930s, the American economist Irving Fisher outlined the dangers of debt deflation dynamics. It starts with the distress-selling of assets by borrowers to reduce their debt. Next, banks' balance sheets contract as customers pay off their debt. A general fall in asset prices creates a further fall in business net worth.
The consequent decline in profits cuts back trade volume, and households feel less confident to spend and investors worry about the future. At the macro level, trade and output falls while unemployment grows, causing more market pessimism. As people begin to hoard cash, the velocity of circulation slows further. This causes a fall in nominal rates, but since inflation may be falling faster, the rise in real rates worsens the debt burden of the borrowers.
The euro zone is in the grip of this depressing state of affairs.
Having just returned from Paris, London and Dublin, I heard only doom and gloom; a normally unflappable euro technocrat even accused the media of trying to kill the euro by fanning more fear. The options for saving the euro appear more limited by the day. There is no doubt in my mind that the German proposal of fiscal union is a sensible solution, because it addresses the structural defect of not having a fiscal mechanism to deal with the side effects of a currency union.
The markets had a temporary rally, even as the new Italian prime minister announced austerity measures to restore confidence in Italian bonds. The interest rate on 10-year Italian bonds duly fell from 7.3per cent a year to 6per cent, but even at that level, the real interest rate (after deducting inflation of 3.3per cent) is 2.7per cent. With the economy growing at near zero and debt at over 100 per cent of gross domestic product, it's not surprising that the markets feel the Italian debt situation is unsustainable.
Thus, while the package agreed by German Chancellor Angela Merkel and French President Nicolas Sarkozy may have staved off disaster for now, financial markets still think they cannot fix a plane in mid-flight. The arithmetic of debt deflation is relentless. High real interest rates deflate asset prices, but bank liabilities in the form of deposits are fixed nominally. So the pressure is on European bank balance sheets.
The banks are in a bind because they hold a lot of European sovereign debt paper, which is deflating in value as real interest rates rise. The European problem is a bank-fiscal bind: the governments have to bail out the banks, but their own fiscal debt overhang is the cause of further deflation.