Back to the Brink for the Eurozone?

The eurozone crisis is back, with yields on Spanish and Italian government bonds inching up again, and equity investors’ mood is souring. The deflationary spiral in these countries is causing output to contract so fast that further spending cuts and tax increases cannot reduce budget deficits and public debt relative to GDP.

ISTANBUL – When European Central Bank President Mario Draghi announced in late July that the ECB would “do whatever it takes” to prevent so-called “re-denomination risk” (the threat that some countries might be forced to give up the euro and reintroduce their own currencies), Spanish and Italian sovereign-bond yields fell immediately. Then, in early September, the ECB’s Council of Governors endorsed Draghi’s vow, further calming markets.

The tide of crisis, it seemed, had begun to turn, particularly after the German Constitutional Court upheld the European Stability Mechanism, Europe’s bailout fund. Despite the ECB’s imposition of conditionality on beneficiaries of its “potentially unlimited” bond purchases, financial markets across Europe and the United States staged a major rally.

It seems, however, that the euphoria was short-lived. Yields on Spanish and Italian government bonds have been inching up again, and equity investors’ mood is souring. So, what went wrong?

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