Over the past few months, the European sovereign debt crisis has become a looking glass for the Anglo-American economics establishment. In Europe, we see warnings of what is to come in the United States: A crisis born of out-of-control deficits, a ballooning welfare state, an innovation slowdown, abysmal monetary policy, foolishly timed austerity, crony capitalism, and a bloated banking sector.
Crises, however, are not fables. They do not exist to teach us lessons or help us learn to mend our ways. The forces at work are utterly indifferent to the narratives we attach to them. Like everything else, they are simply a chain of events. One damned thing after another. Our task is to understand how this chain is likely to unfold and uncover what, if anything, we can do to mitigate the damage.
The most damaging threat out of Europe is clear: a global financial crisis that dwarfs that of 2008, a worldwide recession worse than the Great Depression, and the risk that modern liberal capitalism itself could collapse. That's an ugly list of bad options.
But is it really likely that we could wind up there from here?
Unfortunately, yes. Though most U.S. policymakers seem to think that the United States is insulated from the European economic crisis, the reality is that contagion is just around the corner. A default by a major European government -- say Italy -- would spell the insolvency of all the major banks in that country. Those banks would be unable to meet their obligations to other banks around Europe, causing those banks to go under. In turn, those banks would then be unable to meet their obligations to U.S. and Japanese banks, causing them to go under as well. As banks collapsed, so would the supply of credit, choking off the tremendous daily flow of trade and other transactions dependent upon it. In the resulting scramble for liquidity, firms would be forced to sell assets at whatever price they could get, leading to collapse in worldwide stock and bond market values. This dissolution of wealth would mean that very few households or private organizations would be technically solvent. The value their assets commanded on the open market would not match their liabilities. The crash could be worse than 1929.
These are all paper balance-sheet losses. In theory, the world could go on if everyone acted as if nothing had happened. History, however, suggests they won't. Faced with a collapse in asset values and negative net worth, households and firms will dramatically cut their spending. This, in turn, erodes the income of other households and firms, which makes further defaults more likely, balance sheets ever more negative, and contractions in spending even greater.
This ever-accelerating collapse in spending and income is what we experience as an economic depression.
It is this process that took hold after the collapse of Lehman Brothers in 2008 and the collapse of the Austrian bank Credit Anstalt in 1931, which is widely blamed for the "Greatness" of the Great Depression. Italy's largest bank, Unicredit, is, however, roughly four times larger than Lehman, and France's BNP Paribas nearly eight. And these financial institutions are bound up in each other's success or failure; Unicredit holds Italian debt and BNP Paribas has exposure to Unicredit. The simultaneous collapse of multiple large European banks would set off a shock an order of magnitude greater than what the world experienced four years ago.