Once again the global, and above all the US, financial markets have steered to the brink of an economic meltdown of unprecedented magnitude.
The following preconditions have led up to the current environment: very loose monetary policy and continued accommodation in both the US and the Euro area. Five years into the crisis, politics continue to be one step behind financial markets and thus continue to finance the clearly unsustainable indebted countries such as the PIIGS (Portugal, Ireland, Italy, Greece, Spain) and the US. Fear of contagion has in Europe so far prevented an uncontrolled default on debt while the US appears to have just inflation left as a last bullet in their policy-gun, in order to escape from the gridlock it finds itself in.
The ways out or deeper into the crisis would look like this in Europe, bearing in mind the interdependence with US markets and vice versa:
Continued and expanded fiscal transfers within the EMU (European Monetary Union) together with an ever increasing size of rescue umbrellas. Growth targets for the PIIGS - as envisaged by the IMF for the aid seeking countries to get back to a somewhat sustainable path and compliance to EMU membership criteria - seem highly unrealistic, given the imposed austerity measures and no real potential for growth due to highly uncompetitive price and wage levels. A well planned and sudden debt restructuring would be very painful, however short-lived - compared to the currently planned policies of keeping the half-dead PIIGS patients alive by money injections. Latter would much rather delay, prolong and amplify the damage of a slow default, not to mention a deterioration of international confidence in the Euro and sentiment within the healthier EMU members.
The tax burden among EMU citizens has already fueled social unrest. Again, sooner than any fiscal union within the EMU could have been instituted. And even if a fiscal union was to preserve the Euro, policymakers should carefully evaluate such a union as a potential trigger to a self destructive Euro-time-bomb.
The reason why policymakers probably have not chosen the sudden and controlled default of say Greece is on the one hand the exposure of large German, Swiss and French financial institutions who hold a significant amount of Greek sovereign debt, which would have to be partly written off (again) in case of a credit event. On the other hand the fear of contagion to the EU periphery and beyond bears unpredictable risks.
Looking at the US, its twin deficits (the budget deficit and the current account deficit) are even less sustainable than the PIIGS', regardless of the US' ability to make use of inflation and thus lowering the burden of debt somewhat. Since 2011 the 'fiscal cliff' has become more of a front page story than policy makers would probably have wished for. This looming catastrophe with the official debt ceiling seem to finally have directed markets' attention to the issue of the US' debt sustainability. And by looking closer at the agreed measures of spending cuts (close to $1 trillion over the next decade), it should be noted that the CBO's projection made in 2011 for US GDP growth of around 2.8% y/y for 2012 is probably as poor as the 3.1% y/y projection it made in the beginning of 2011 for the same year.
According to the Office of Management and Budget in 2011, a one percentage point lower than forecast growth would lead to an increase in cumulative federal deficits of $750 bn over ten years.
Recent reports of the secret meeting that EMU finance ministers held indicate just how precarious world financial markets have become.
This event, along with the massive plunges and subsequent ballooning (after the respective QE programs) in world financial asset prices highlight the narrow path that markets have ventured: at the tip of an unprecedented collapse of unregulated capitalism, it seems to need only a small push for the first of the domino pieces to fall. Such an event could be the default of a single bank, a terrorist attack or merely an escalation in social unrest anywhere in the world.
The outlook is dim at best, considering the interdependencies of institutions, markets and monetary unions, while all attempted remedies to try to calm the markets seem to have failed so far.
The ECB will unlikely resort to inflating the Euro area out of the crisis, leaving few options but a debt restructuring of some sort for the PIIGS. The US in the meanwhile will most likely embrace further quantitative easing and camouflaging inflation, thus debasing the greenback and reducing real wealth.
A likely change of rhetoric at the Federal Reserve - e.g. by stating to begin target nominal GDP growth - could make not just the financial media open their eyes to a new era of wealth erosion and wealth re-distribution. The only real question is weather global financial markets will keep their calm or rather initiate a chaotic bursting of the bond markets and whatever else is to follow.