Published on Real-World Economics Review Blog, by Dean Baker, Nov. 18, 2011.
… There will likely be a wave of bank collapses as banks are forced to write down much of the debt they hold in Italy, Ireland and other heavily indebted countries. This would bring about another Lehman-type situation where finance freezes up. Banks would stop lending to each other and even healthy businesses would find it difficult to obtain credit.
That is the story of a severe double-dip in the eurozone, with the spillover effect almost certainly pushing the United States and most of the rest of the world into recession. It could easily be over a decade until these economies recover from the damage.
The absurdity of this story is that such a collapse could be easily prevented. The recipe is simple. The European Central Bank (ECB) must agree to backdrop the debt of Italy and most of the other heavily indebted countries, after a write-down of Greek debt. It should also have an expansionary policy that allows somewhat higher inflation in Germany so that the peripheral countries can regain competitiveness by having lower positive inflation rates.
The current low inflation rate in Germany, requires that Spain, Italy and other peripheral countries actually have deflation to improve their competitiveness. This is difficult to accomplish and likely to lead to many years of slow growth and high unemployment in these countries.
While the basic logic of the situation should be apparent even to people without formal training in economics, the ECB seems oblivious to it. The preferred path from the ECB, along with its partners the IMF and the European Union, is to require that the heavily indebted countries just keep cutting their deficits. This leads to further reductions in demand, which causes higher unemployment. As the unemployment rate rises, tax collections fall and payment for transfer programs like unemployment benefits increase. The result is that the deficits get larger and the debt-to-GDP ratio rises.
The absurdity of the ECB agenda should have become apparent even to its top officials when they came up with the idea of a new expanded bailout fund. To make the fund more potent, the ECB sent emissaries to China, Brazil, India, and Russia to encourage them to lend money to the fund … //
… The absurdity of this situation is that the eurozone countries would not need outside support from the BRICs if the ECB were prepared to pursue these policies today. Just as is the case now with the United States, there is no shortage of wealth in the EU, in the sense that it has the ability to produce vastly more goods and services than it is producing. The main problem is simply a lack of demand.
We have known how to generate demand since Keynes wrote his masterpiece in the 30s. However rather than pursue the simple steps needed to restore the eurozone’s economy to stable growth, the ECB is adhering to an ideological agenda that will destroy the euro and throw the economy into an even more severe recession than the last one. This is an extraordinary tragedy unraveling in slow motion in front of the world. (full text).