7d3ec00446f86f480f00ca00_pa3658c.jpg Paul Lachine

Europe’s Vicious Spirals

While 2011 was supposed to be the year when European leaders finally got a grip on events, the eurozone’s problems went from bad to worse. The problem is not just that Europe faces a sovereign-debt crisis, but also that it faces a growth crisis, which worsens the debt problem.

BERKELEY – The euro crisis shows no signs of letting up. While 2011 was supposed to be the year when European leaders finally got a grip on events, the eurozone’s problems went from bad to worse. What had been a Greek crisis became a southern European crisis and then a pan-European crisis. Indeed, by the end of the year, banks and governments had begun making contingency plans for the collapse of the monetary union.

None of this was inevitable. Rather, it reflected European leaders’ failure to stop a pair of vicious spirals.

The first spiral ran from public debt to the banks and back to public debt. Doubts about whether governments would be able to service their debts caused borrowing costs to soar and bond prices to plummet. But, critically, these debt crises undermined confidence in Europe’s banks, which held many of the bonds in question. Unable to borrow, the banks became unable to lend. As economies then weakened, the prospects for fiscal consolidation grew dimmer. Bond prices then fell further, damaging European banks even more.

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