Europe’s Debt-Relief Calculus

SANTIAGO – Europe has long been menaced by the threat of two crises. The first would erupt with a successful speculative attack on a large eurozone country’s bonds, immediately jeopardizing the single currency’s survival. European Central Bank President Mario Draghi’s vow to do “whatever it takes” to prevent a sovereign default in the eurozone seems to have diminished that danger – at least for now.

The other looming danger is a growth crisis – a threat that has become increasingly serious. The ECB’s most recent macroeconomic forecast, which cut expected GDP growth for both 2012 and 2013, makes the threat all too clear: The eurozone will certainly contract this year, and grow by just 0.3%, at best, next year.

Europe persistently undershoots its growth targets because European policymakers persistently underestimate fiscal multipliers, pursuing austerity instead. And slower growth means lower revenues, which imply larger deficits and heavier debt burdens – at which point, as Wolfgang Munchau of the Financial Times and others have stressed, the entire belt-tightening exercise begins to look self-defeating.

This is all pretty worrisome. But things could get worse. The problem is not just that slow growth is driving up debt levels. It is also increasingly plausible that the debt overhang is itself becoming the cause of slow growth.