Dr. Doom Sees More Doom

Nouriel Roubini, a professor from NYU most famous for predicting the housing collapse, sees more disaster ahead. Writing in the Financial Times, Roubini, nicknamed Dr. Doom for predicting disaster in the housing market when everyone else was riding high, spells out the problem facing Europe, and thus the rest of the world.

Italy is too-big-to-fail, but also too-big-to bail. Even if it restructured its debt (2.58 trillion USD), it would still suffer from “a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.” To resolve those problems Italy may “need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone.”

Until recently the argument was being made that Italy and Spain, unlike the clearly insolvent Greece, were illiquid but solvent given austerity and reforms. But once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable.

Roubini continues:

So Italy and other illiquid, but solvent, sovereigns need a “big bazooka” to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone.

He explains that Eurobonds are out of the question due to German politics – they’ve bailed out enough people, they say (rightly) – and the ECB is prevented from doing so: “as unlimited support of these countries would be obviously illegal and against the treaty no-bailout clause.” Roubini also dismisses other discussed options as ineffective or unrealistic.

The austerity necessary to pay down the debt and save the credit ratings, he argues, will make the recession worse: “Raising taxes, cutting spending and getting rid of inefficient labour and capital during structural reforms have a negative effect on disposable income, jobs, aggregate demand and supply. ”

Even a restructuring of the debt – that will cause significant damage and losses to creditors in Italy and abroad – will not restore growth and competitiveness. That requires a real depreciation that cannot occur via a weaker euro given German and ECB policies.

If you cannot devalue, grow, or deflate to a real depreciation, you must abandon the Euro. The eurozone could survive Greece or Portugal doing so, but not Italy (or Spain). That would effectively break-up the eurozone. That “slow-motion train wreck is now increasingly likely.”

Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster.

There are even odds that this will happen. Berlusconi has resigned as prime minister, but that will only calm the markets for so long. The structural problem of their debt remains. As does the threat of the collapse of the euro. They will continue regardless of who hosts the next bunga bunga party.

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