Europe faces “horrifying choices”

The outcome of the European debt crisis is “genuinely unpredictable” with politicians facing “horrifying” choices, according to Martin Wolf, associate editor of the Financial Times, who spoke in Ottawa Monday at an event organized by Canada 2020.

Wolf says the extraordinary monetary and fiscal policies brought in following the economic collapse and deep recession of 2008 and 2009 have led to “an incredibly feeble recovery” around the world and have created a second stage to the crisis.

“In the end, the financial crisis morphs into a sovereign debt crisis,” Wolf said. “When you have that, there isn’t anyone to save those in crisis except other sovereigns. The really big question that we are now confronting in Europe is whether other sovereigns are going to save insolvent sovereigns—that’s the core of the crisis. You’ll have a mixture of a sovereign debt crisis and a banking crisis. That’s where we are now.”

Wolf believes that despite the scale of the interventions, Europe remains in recession. “We’re in no way out of this. The right question is whether we can avoid a depression. That’s really the issue. A mild recession would be difficult, particularly so soon after the last one, but we can live with that. The question is whether we might risk something much worse than that.”

Wolf, an author and lecturer as well as a journalist, says Europe faces two realistic options. First, allow the countries facing borrowing problems to default. “Which means that their banks will go down and you have a massive banking crisis across the eurozone.”

Such a move could also lead to the breakup of the eurozone, which would be a catastrophic event, Wolf says, because the region is now completely interlinked. “You’re going to have runs on all the weak currency countries. In fact, those banking systems are going to implode completely. That will also destroy the European Central Bank. While this is happening, the economies of the countries experiencing the run will collapse—we’re experiencing a little bit of that now. So you would have a series of events that would be massively disruptive. That destroys the European economy so breakup is unthinkable.”

Alternatively, the countries in crisis could be bailed out. But there’s a fear this will lead to a “Japanese-style experience” of endless and open-ended transfer of funds to deal with existing debt and continuing deficits. Reports today suggest European leaders are considering a $2-trillion rescue package, but there is doubt over whether the plan will be approved.

“This is the bottom line struggle in the eurozone. It’s a massive political issue. We face some extraordinarily big decisions by European governments in the next several months. If they make certain decisions, we will see a series of government and banking collapses and if they make other, different decisions the eurozone will become much like a country. I really don’t know which they will choose and neither do they. That’s why the central bank governors are terrified out of their wits and so should you be.”

Despite the uncertainty, Wolf believes Europe’s politicians are more likely to decide to maintain the union and go with the transfers. “Meanwhile, the political mood in Europe has become poisonous and that makes it all the more difficult to reach a cooperative solution. And this isn’t a local problem. Europe has the biggest banking system in the world and the eurozone is pretty much as big as the U.S.—you will all feel it.”

The situation in the United States is also dire, Wolf says, with the country needing to run a massive fiscal deficit, despite political opposition. “With the confidence shocks we are seeing, I’d be very surprised if the U.S. avoids a recession,” he said.

“The Fed, if it were extraordinarily aggressive, might change that, but in the U.S. at the moment, the corporate, household and foreign sectors are running gigantic surpluses and there’s no sign of that changing. There are no easy tools to get corporations to spend. Why should they invest when there is no demand? In this situation, I fear that there will be a fiscal tightening and unless something remarkable happens, it’s going to be pretty difficult. We are looking at a lost decade for the United States.”