We are still not out of the woods in Europe. Right now, perhaps the most interesting barometer on the state of Europe is the yield on the Italian 10-year note. It is currently yielding 6.22%, a spread of 4.40% higher than the German 10-year note. Before the Euro-crisis started, the difference in yields between the two countries was minimal.
If the level stays there, then Italy is going to be stuck in a self-perpetuating downward spiral. The higher interest rate means that Italy needs to spend more on interest payments. To do so Italy has to cut other spending or raise taxes. That, in turn, slows the economy. With a slow economy, the Italian debt becomes more risky, leading investors to demand a still-higher interest rate. Lather, rinse, repeat.
One option that is not open to Italy — or any other country on the Euro — is having the central bank buy the bonds, nor is it able to devalue the currency to become more competitive. It is as if all of its debt is denominated in a foreign currency. The actual debt and deficit picture — particularly the deficit before you factor in interest payments — in Italy is not substantially worse than that of the UK or Japan. Those countries can still borrow at very reasonable rates (in the case of the UK 2.31%, or just a little bit over the 1.82% in Germany).
Japan has long had the lowest interest rates in the world, despite a debt-to-GDP level that makes Greece look like a paragon of fiscal virtue. The difference is that they both have their own currency and their own Central Bank. All things considered, it looks like the world would have probably been better off if the Maastricht Treaty were never signed, and the world still had the Mark, the Franc, Lira, Drachma and Guilder. But unscrambling that egg would be extremely difficult and would cause massive disruptions.
Change of Leadership at the ECB
The European Central Bank, or ECB, got a new head as Mario Draghi replaced Jean Claude Trichet. All I can say is goodbye and good riddance to Mssr. Trichet. The ECB has been worse than useless in the whole Euro crisis — actually raising interest rates, thus tightening monetary policy twice over the last year.
The ECB is the one institution that if it wanted to could make a huge impact on defusing the Euro crisis. It could agree that it will buy the bonds of Italy and Spain in big enough quantities to make any speculator know that he is on a suicide mission if he attacks either country. Yes, that might lead to somewhat higher inflation in Europe, but at least the periphery countries would not have to bear the full brunt of things via internal devaluation and deflation.
Draghi’s first day on the job had to be a memorable one, stepping into the job just as the Greeks were threatening to blow up the deal worked out the week before with the referendum. He made a bit of a splash in his first week by lowering the Euro equivalent of the Fed Funds rate to 1.25% from 1.50%. Very much a step in the right direction.
While on the topic of Central Banking, the Fed held a meeting and decided not to take any more steps towards stimulating the economy at this time. Three members of the FOMC that dissented last time were on board. However, Charles Evans of Chicago dissented, saying that the Fed needs to do more.
The Fed also revised its economic forecasts, and not for the better. They are now looking for growth to be just 1.6% to 1.7% for this year, down from a 2.7% to 2.9% range back in June, and the 3.4% to 3.9% growth they were looking for at the beginning of the year. The forecast for 2012 was also revised down sharply, to a 2.5% to 2.9% range, from a 3.3% to 3.7% forecast in June. The table below (from this source) shows the trend for each year.
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