EZ rescue or recession: Fallout of the October 2011 package

by Richard Baldwin

Vox
October 28, 2011

Markets loved the EZ rescue. This column argues that it was short-term good news in that it defused ‘the bomb’ – a catastrophe vortex of failing banks and defaulting sovereigns. The bad news is that the rescue will induce a recession. Banks will create a credit crunch in trying to meet capital adequacy ratios, and the renewed emphasis on austerity will create a fiscal contraction. The resulting recession will weaken banks, sovereigns, and Greece. We’ll be needing another crisis summit by Spring 2012.

Almost nothing decided at the latest Eurozone Summit was a surprise. For many months, economists on Vox have identified six elements that are essential to turning the Eurozone into a sustainable endeavour (see Wyplosz 2011, De Grauwe 2011, Baldwin and Gros 2010, etc).

Three measures were urgent and necessary to rule out the possibility of a catastrophic explosion of Europe’s banks and sovereign debt markets – or to put it colloquially – to defuse ‘the bomb’. These are:

• Fix Greece
• Backstop the banks
• Backstop the sovereigns

This is what Thursday morning’s package addressed. With the bomb finally off the table, markets soared.

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