The big danger is Europe

„First, the European Central Bank — Europe’s Federal Reserve — tries to stabilize financial markets by buying the bonds of besieged debtor nations. It’s already bought Greek, Irish and Portuguese bonds; now it’s buying Italian and Spanish bonds. But where does this stop? The ECB is acting reluctantly, because it fears that excessive bond purchases (»monetizing« government debt) would unleash an inflationary flood of money. This approach is Muddling Through 2.0.

Second, the International Monetary Fund organizes a global rescue package worth trillions of euros. Europe’s debtor nations could borrow at low rates with long maturities. Once debt pressures were relieved, Europe could follow more pro-growth economic policies. But any package would have to be heavily financed by countries with huge foreign exchange reserves, meaning oil producers and — most importantly — China, with reserves of $3.2 trillion.

Third, some European nations could negotiate write-downs on their debts or default on them. Superficially, this seems a solution. But it would create other problems. Defaults would inflict huge losses on banks, insurance companies and pensions. Many European banks might collapse unless rescued. Who would rescue them? Confidence would plunge. A recession would seem unavoidable. Defaulting countries would also have trouble borrowing in the future.

All these possibilities involve momentous political, economic and technical uncertainties. What if the crisis spreads from Italy to Belgium or France? Would China contemplate bailing out Europe? If it did, there would be a stunning transfer of geopolitical power and prestige to China. Can the ECB (or the Fed) buy endless quantities of government bonds without someday fueling inflationary expectations? The questions swirling around Europe are terrible to contemplate. But they will not soon go away.”