Why Europe Is Spooking Stock Markets

The stock markets have picked up a bad case of the jitters recently, providing more fodder for the theory that investors don't do well with the approach of Halloween.

One of the scariest apparitions haunting the trading floors now is the prospect that Europe is entering a prolonged period of stagnation similar to Japan's "lost decade" - but at a higher level of unemployment. That could be a long-term drag on the American economy and terrible news for millions of Europeans. It also sets the stage for potential political turmoil on the continent, where far-right parties have been on the rise.

I recently caught up on the European situation with a trio of experts at Johns Hopkins University: Jonathan Wright and Robert Barbera of the economics department and Nicolas Jabko of the politics department. Our conversation was part of a regular roundtable on the Eurozone economy, and it went through some editing and elaboration by e-mail after we were done talking. Read on for excerpts, or check out the whole thing over at the JHU Center for Financial Economics.

We've heard a lot of concern that the Eurozone will go into deflation, as Japan did during its "lost decade." Just for background, what's the problem with deflation?

Wright: Deflation is going to get you into a spiral. It's happening in the context of an economy that's weak. With deflation, your real interest-rates (are forced to be) positive, whereas you would like them to be zero or negative. Positive real interest-rates are going to weaken your demand even further. And, this is in a situation where you really would like to transfer assets from the creditors to the debtors, (but) you're going to have exactly the opposite. In a deflationary world, the real value of debt is going up. Deflation is just making those imbalances worse.

So how likely is this to happen in the Eurozone?

Jabko: You could have stagnation without deflation. It would be pretty bad still. So it may not be Japan. But it may still be very bad.

Barbera: If you have stagnation without deflation, but you're doing it from a 14 percent unemployment rate instead of 4, it's much worse than Japan.

Wright: It's not hard to see how you get the Eurozone as a whole into outright deflation mode - significant odds of that. And parts of the Eurozone are already there.

What are the prospects for fiscal stimulus to give the economy a shot in the arm?

Jabko: The problem is that the fiscal situation is very uneven across the member states. The one member state that would be most able to do stimulative fiscal policy is Germany - yet is it the member state that is the least likely to do it because the economy is doing a lot better than the other member states from the perspective of unemployment. And most importantly, any kind of fiscal deficit in Germany is very unpopular. None of the other member states is able to do significant fiscal stimulus because they don't have as much as fiscal maneuvering room as Germany. Germany is the only country that could do significant fiscal stimulus and yet they don't.

Of course, European Central Bank chief Mario Draghi recently intervened in this debate, urging Eurozone governments to spend more.

Jabko: Yeah, exactly, which was a first because the central bank had never said that. And usually they say quite the opposite. And this time, Draghi said there should be more spending - or, more time for fiscal consolidation, which in practice means more spending now. It turns the tables against Germany, so that now Germany is no longer the model that everybody needs to imitate. Germany is in the seat of the accused, and that is a completely new development.

Meanwhile, Draghi has been busy tinkering with monetary policy. For one thing, he recently loosened the terms on which the European Central Bank would lend money to commercial banks. Where did that go?

Barbera: What he said was, you can borrow for four years at today's overnight interest rate. So you lock in zero for four years. But the banks didn't touch it.

Jabko: The reason why the banks didn't really buy into this was that in exchange for doing that they had to promise that they would lend that money to households and businesses.

Barbera: I've heard a different (explanation). If you go in and take that money then you get a disproportionately large amount of inquiry about what you're doing. So it was a desire to not feel that you're at the beck and call of the authorities.

Wright: Perhaps because a bank stress-test is coming up. You don't want to blow your balance sheet up just in advance of a bank stress-test.

So the attempt to increase bank-lending failed. What did Draghi do next?

Barbera: He came out and he said that they were going to meaningfully increase the European Central Bank's balance sheet by buying billions of asset-backed securities. But when we looked at the definition of the securities he was willing to buy, they as yet weren't there in any size. They're private-sector securities that are not robust markets now.

Jabko: The ECB had previously justified not doing what they've announced they would do now by the fact that European finance is mostly bank-based lending as opposed to financial-market operations. So they focused on bank lending earlier. That didn't work. So now they're trying desperately to expand their balance sheet.

Is there a chance that the mix of assets Draghi is willing to buy will change?

Wright: He can buy a weighted basket of Eurozone government bonds. In fact, the current level of yield (in the bond markets) is almost pricing in the expectation that he will. (But) today, I don't see how monetary policy can pull the Eurozone out of this rut.

How does the global economic outlook factor into all this?

Barbera: The data in China looks really bad. And beggar thy neighbor is very hard to do if all the neighbors are having a tough time. So there's an interesting dynamic here. As a potential additional confusion, if China does very poorly, you will import deflation from China, as they dump stuff on your economy. And it will also make the U.S. much less compliant, in terms of being on the flipside of a big Euro decline.

Jabko: That's also a ray of hope, paradoxically because Germany is not doing well. During the Great Recession, Germany was doing relatively well, because it was basically exporting its way out of Europe's trouble. Although Europe and the US were in recession, many emerging markets were still growing strong. Now if these countries start not doing so well, or being hit by export restrictions in the case of Russia, then German exports to these countries go down, and the economy goes in a dip, which is a new factor. And if that happens, then it is at least conceivable that the German government might become more open to fiscal stimulus, in a way it was not before. But they probably will not call it that.

Any last words?

Barbera: Politicians know it rarely pays to admit you erred. But I have to believe that behind closed doors, faith in the virtues of fiscal belt-tightening has to be somewhat shaken in Europe. Nicolas, is there any reason to expect that Europe can be more sensible about budget issues going forward?

: Yes. Jean-Claude Juncker is about to become president of the new European Commission. Many observers have hopes that he will be more active than (his predecessor, Manuel) Barroso, who was widely criticized for his lack of leadership. Juncker has called for a €300 billion Europe-wide investment plan to be funded by the European Investment Bank (EIB) and the private sector. In addition, Pierre Moscovici, a French Socialist, is now becoming the commissioner for economic and financial affairs. As the official who oversees member states' adherence to the growth-and-stability pact, he obviously cannot afford to favor France or other states struggling to remain within the deficit limits of the pact. However, he is also expected to act with more pragmatism than his predecessor.

Barbera: Well, that might well give Draghi something to think about. If the (EIB) raises a small sum, perhaps the ECB can find a way to reinterpret rules and lend aggressively to the EIB. And the timing of such a plan?

Jabko: No doubt at least a year.

Barbera: Uh-oh. It doesn't feel like the world has another year's worth of patience.