Europe’s debt crisis is still likely to end badly

There are two main schools of thought on what may happen next with Europe’s debt crisis. Some well-informed people strongly believe that everything will work out just fine, and without much of an economic slowdown. Other, equally well-informed people believe just as strongly that the euro area will break apart in a traumatic manner. When it comes to predicting Europe’s future, not many people occupy the middle ground.

The two poles now agree that the severity of the crisis largely comes down to Italy and the European Central Bank. The optimists argue that Mario Monti will save the day. Not only will Italy’s new prime minister push through some reasonable austerity measures, the optimists insist, he will also persuade Germany not to demand yet more budget cuts. The sympathy and support of the German government matters a great deal, primarily because of its influence with the ECB.

If we were still living under the “no bailout” conditions of the gold standard, as it actually operated before 1914, Italy would have no hope. The market has decided that Italy has too much debt and too little growth. As these expectations become more negative and interest rates rise, it becomes harder for Italy to issue new debt and make the required payments on existing obligations. Projected government debt levels become explosive.

Today’s world, of course, has moved far from the gold standard because central banks can provide credit and create money. The central banks are limited only by their credibility, or the level of confidence by the financial system that policy makers will keep inflation in check.

The ECB has, in the jargon of the day, a big bazooka. It can provide a great deal of cheap credit to Italy and other troubled European sovereigns. If Italy doesn’t need to borrow from private markets for the next few years, the reasoning goes, an economic recovery can take hold. There may also be sensible changes at the level of euro-area governance, including perhaps a greater degree of fiscal union. And Germany could throw some fiscal stimulus into the mix.

My colleagues at the Peterson Institute for International Economics, Fred Bergsten and Jacob Kirkegaard, have a new paper: “The Coming Resolution of the European Crisis,” which argues that such outcomes constitute the most likely scenario.

They quote Jean Monnet, a driving force behind European integration, who said “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.” Politicians, Bergsten and Kirkegaard believe, will rise to meet the occasion.

I’m in the more skeptical camp. Peter Boone and I also have a new paper, “The European Crisis Deepens,” which reviews a range of scenarios and concludes that the euro area is likely to end badly.

If this were just an exchange system on the brink of collapse, we wouldn’t care that much. History is full of fixed exchange-rate arrangements that broke down. In fact, a cynic might even point out that all attempts to fix exchange rates, whether against gold, the dollar or other currencies, ultimately fail.

Think about the gold standard in its various permutations: the post-World War II Bretton Woods system, attempts by East Asian countries to peg their exchange rates in the 1990s, or even the ultimately disastrous Argentine currency peg from 1991 to 2002. They all illustrate that holding on to an exchange peg for too long is a classic policy mistake. Usually when it ends, there is a great deal of concern about the future, but such worries are often overblown: A depreciation in the exchange rate can help an economic recovery, as long as the lid can be kept on inflation.

But Europe’s problem isn’t just that some countries have the wrong exchange rate, and no way to adjust it within the existing system. The main issue is that governments borrowed heavily during the good times, which are most definitely at an end.

Italy has more than 1.9 trillion euros ($2.5 trillion) in debt outstanding. Bringing this under control through austerity alone is unlikely to work. In countries such as Greece and Ireland, the economic contraction is further undermining fiscal sustainability.

If the ECB buys a great deal of Italian debt or finances banks that are willing to do the same, it might stabilize the situation for a while. But how much can the ECB really do without jeopardizing its credibility? How long will long-term interest rates stay low, even if short-term inflation accelerates? What will happen to inflation expectations if the ECB continues to expand credit in this fashion?

Many people, including leading bankers and those with access to the highest levels of government, want to prevent any kind of Italian debt restructuring. But at some point in every fixed exchange-rate regime, even the most powerful people have to confront basic arithmetic. When budget deficits cannot be financed, when enough capital is flowing out, and when the central bank has gone beyond the limits of what is responsible, it is always time to move the exchange rate.

When the country that devalues has borrowed heavily in a foreign currency -- as the euro effectively is for Italy at this point -- there is a sovereign debt crisis and usually a restructuring of the government’s obligations. Avoiding some version of this in the euro area will be hard.

(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, is a Bloomberg View columnist. The opinions expressed are his own.)