On Wednesday, the head of the International Monetary Fund, Christine Lagarde, said that the European debt crisis risked plunging the whole world into a “lost decade.” According to Lagarde, it’s up to rich countries to help us—countries, that is—grow again and regain our confidence.
Then, yesterday, the European Union slashed its growth forecast and said that there’s a real risk of a “deep and prolonged” recession.
The phrase “lost decade” dates back to the nagging deflation, debt and stagnant economy that plagued Japan after its own real estate bubble burst in the early 1990s. Many analysts are concerned that Europe could face a similar economic scenario.
This Week in Italy
First, Italian Prime Minister Silvio Berlusconi agreed to step down from his post once the Italian Parliament passed the austerity measures demanded by the EU. Currently, he’s expected to step down on Monday. This comes at the same time as the resignation of Greek Prime Minister George Papandreou.
(For more on what happened in Greece last week and why Papandreou was ousted, read this.)
In Italy and in the whole world, Wednesday was a panicky day as investors drove the rates for Italian bond yields well above 7%, the widely accepted threshold for unsustainable levels. Basically, for a country to borrow money, it has to pay interest to its lenders, so it sells bonds and pays out “yields,” or an income return for those investors.
But if you were an investor, you’d want more interest in exchange for taking on a riskier investment, right? The more investors fear they might not get their money back from the loans they lend, the more interest they demand. That’s what happened this week—investors were skeptical enough of Italy’s ability to pay back loans that the cost for the country to borrow money jumped twice as high as it had been even a month ago.
That might not be so bad for investors, but it has the potential to turn into a vicious cycle for countries already struggling under a heavy debt burden.
Wait, Now the Problem Is Italy?
Although until now Greece has been central to this crisis, Greek debt woes can be contagious. One of the big fears in this crisis is that there could be a domino effect: Greece can’t pay back its debtors, many of which are other countries. If Greece defaults, then those other countries are out a ton of cash. So if they were at all tenuous in their cash reserves against their own debts, now they’ve lost a big chunk of change, and might teeter into crises of their own.
That’s the case with Italy, which holds a lot of Greek debt. And so the dominoes fall: With the turmoil in Italy, it’ll be harder for Ireland to convince markets and investors that it’s immune, and so on.
So What’s Everyone Going to Do About It?
By way of intervention, the European Central Bank bought large amounts of Italian bonds, which brought Italian 10-year yields to 6.7% on Thursday, down from 7.4%.
That said, the ECB is hesitant to do more. Earlier, on Monday, euro zone finance ministers agreed on a road map for beefing up the region’s rescue fund for larger economies, and IMF managing director Lagarde said she was hopeful the details of that package would be ready by December. But there’s ongoing debate as to whether that bailout fund is enough on its own, and whether the ECB should only act as a lender of last resort. Germany, one of the most fiscally conservative countries in Europe, is opposed to the ECB getting too involved, as it doesn’t want to shoulder a disproportionate burden to save the rest of Europe.
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By Thursday, the markets mellowed out from their alarmist drop the day before, but some investors and analysts view Italy’s bond market as a sort of proxy for the euro zone’s deeper problems, like Greece’s potential exit from the euro currency and Germany’s urge to avoid bearing too much of the financial burden of rescuing everyone else.
China to the Rescue?
In need of a rescue, European policymakers are hopeful that countries like China might invest huge sums to help end the debt crisis … but there’s skepticism within China, too, because that would amount to bailing out countries with far higher average incomes than China itself. Plus, there are worries about Europe’s political will, because many of the decision-makers in this crisis are politicians who are trying as they might to stay in power and win reelections.
Although people have said this in every generation, we do feel that we’re living in historic times. For now, we’re watching the market—and markets all over the world—to see what happens next.
(For the different global markets and how they shed light on the state of the economy, read this.)