They stand out, don’t they? Things have been quiet in the Eurozone lately, but today the cost of insuring Greek government bonds set a new record by surging past $1 million (to cover $10 million for five years). The price is said to imply a 67 percent probability of default in the next five years. The full story is here.

The Bank for International Settlements has released its quarterly review (hat tip EconBrowser). In it, you will find an interesting graph on page 19 (or page 23 including cover pages), titled “Exposures to Greece, Ireland, Portugal, and Spain by nationality of banks”. It’s reproduced here on the left (click on it for a larger view).

I am puzzled by the relatively small size of public sector debt compared to the quite significant contribution of private sector debt in the countries discussed. Is fiscal austerity really going to be a solution?

I wonder how in the world cautious German and smart French banks ended up with so much exposure to private debt in Spain. Of course, ingenious American banks are disproportionately exposed to financial products rather than straightforward debt. It seems financial reforms of different kinds are required in different places.

The Economist takes a look at European austerity plans and finds…not much. Substantial cuts are happening mainly in the smallest Eurozone countries. Overall the impact is slight, although of course cutting anything at all is still the opposite of stimulus.

This posting is by Levy senior scholar Philip Arestis, University of Cambridge and University of the Basque Country, and Theodore Pelagidis, European Institute, London School of Economics and University of Piraeus.

A spectre is haunting Europe—the spectre of austerity. All the powers of old Europe have entered into an unholy alliance to exercise this spectre, about which all of us should be depressed. Europe probably will be soon enough.

Why this sudden emphasis on austerity, when the well-known lessons of history are that in times of recession fiscal stimulus is the best medicine? Some European countries are chronic over-spenders of course, but others with strong balance sheets have announced austerity programs as well. Why? The short answer is that it is all about the banks.

Europe’s financial institutions are loaded with potentially toxic sovereign debt issued by Greece and other shaky countries around the European periphery. French banks are said to be loaded with 75 billion euros of toxic Greek bonds; one can now understand President Sarkozy’s furious campaign to rescue Greece. Taken together, Spain, Greece and Portugal are believed to have planted a 2.2 trillion euro time bomb on the balance sheets of European banks.

The value of these assets has already plunged, threatening bank solvency, choking off lending and leaving the taxpayers of such solvent nations as Germany with Hobson’s choice: foot the bill for the prodigality of Greece and other euro area nations in similar positions, or bear the expense of bailing out their own banks. Doing neither, for now at least, appears to be unthinkable.

Thus the continent-wide turn toward austerity. If state budgets are restricted, so the magical thinking goes, wonderful things will happen. Sovereign bond prices will rise, rescuing imperilled banks. Moribund interbank lending will be resuscitated. Government borrowing costs will decline. Economies will be reinvigorated. The embrace of austerity is also easier to understand in a political context. It is clear that European politicians are incapable of directing stimulus to productive ends, and the public continues to reject tax increases to cover the future deficits that today’s stimulus would create.

The problem is that embarking on austerity now will only make a bad situation worse. In fact austerity increases the risk of a great many dreaded outcomes in Europe, including negative GDP growth, sovereign default, political instability and shuttered capital markets. These things make bank failures more likely, not less. It is actually the lack of a more powerful and more systematic stimulus that raises the risks of a double-dip recession. In Europe in particular, the near absence of a stimulus has brought the euro area very close to dissolution. It is the deep and prolonged recession that finally revealed member-states’ huge public debts, and made borrowing so expensive for most of the member-states and unbearable for others (Greece). Banks suffer by keeping trillions in devalued sovereign bonds hidden on their balance sheets; and nobody really knows which and how many banks are in this tragic situation. Would draconian cuts in the context of Europe’s fragile growth rate solve the problem? Surely not.

What is needed right now is spending, not saving, particularly in Germany. It is noteworthy that in the U.S., this kind of Keynesianism—mixing consuming and investment budgetary expenses with some tax credits—saved the system from collapse in 2009 and retained, to a great extent, a certain satisfactory level of economic activity.

The ‘over-borrowing’ of Greece and other European countries in a similar position should not be attributed to naïve Keynesianism. The real problem is that these countries, by joining the Euro, have deprived themselves of an appropriate domestic monetary policy. An extremely hard euro policy combined with cheap credit quickly eroded domestic competitiveness while raising demand for imports, which had become cheaper. The result was a ballooning current account deficit that reached 14% of GDP in Greece (2008), a deficit that requires corresponding capital inflows. Given declining domestic competitiveness, these flows could not be foreign direct investment. Thus, the government had to take over and sell bonds to finance a fast-deteriorating current account.

So if austerity is not the answer, what should be done to help the weakest Mediterranean countries stabilize their economies and thereby avoid a painful dissolution of the European Monetary Union? Aside from the perennial problem of Greece, where governments always lie about deficits and citizens always lie about their income, we should not forget the responsibilities of the EMU itself. It should have acted differently long ago, but it is not too late for it to change course in time to avert disaster. There are three important steps to be taken, all of them at odds with what the G20 decided in the first week of June.

First and foremost, the European Central Bank should buy as many toxic sovereign bonds as necessary to stabilize the market. Second, ECB should lower interest rates close to zero, as has been done in the United States. Last but not least, countries with huge surpluses, such as Germany, should be convinced to spend more and tax less, which means smaller current-account deficits for the weaker EMU partners and possibly a little more inflation for Germany. It is completely absurd for any surplus country within a monetary union to implement austerity measures while maintaining a current account surplus.

In sum, if contractionary policy prevails globally and especially around Europe, Greece and similar countries might find it even harder to drive their economies through an export-led recovery. It would then be easy to predict what will happen to those banks keeping toxic skeletons in their closets.

Bloomberg polled international subscribers to its Bloomberg Professional Service and found that 73 percent expect a Greek default. These subscribers are described as decision-makers in finance, economics etc. The full story is here. You can also read the poll and results for yourself by clicking on the “attachment” tab at the top of the window. This will take you a pdf that is unfortunately missing the file extension. Just rename it to add .pdf to the end and it will open normally.

In a sobering column in the Financial Times, Edward Chancellor reminds us that the late Wynne Godley was right in predicting that large private deficits in the U.S. would lead to trouble–and that the Eurozone, when it was formed, might become a tragic disinflationary trap. The end of the column is particularly noteworthy:

He went on to caution that without a common European budget, there was a danger that “the budgetary restraint to which governments are individually committed will impart a disinflationary bias that locks Europe as a whole into a depression that it is powerless to lift”.

Rob Parenteau, a fellow Levy Institute scholar, has recently applied Prof Godley’s analysis to the eurozone periphery. Germany wants countries, such as Spain, to get their public finances in order. Yet if Spain is to reduce its fiscal deficit without too much pain, two conditions are necessary. First, the country’s trade position must shift into surplus. This is problematic since labour costs are high relative to Germany and Spain cannot devalue its currency. Second, the private sector must move back into deficit. Yet it is difficult to see Spanish households and companies wanting to borrow more given the ongoing problems caused by the collapse of the property bubble.

There is a danger the proposed fiscal tightening in the eurozone will lead to further deflation and economic collapse. The Spanish government faces what Mr Parenteau calls “the paradox of public thrift”: the less it borrows, the more it will end up owing. It is unfortunate that it has taken a severe global recession to vindicate Prof Godley’s macroeconomic analysis. If economic policymakers start to pay more attention to financial balances, they might forestall the next crisis. European politicians might also understand the potentially dreadful consequences of their new-found frugality.

You can read some of Rob’s analysis for yourself here. Chancellor, by the way, is the author of a good book called Devil Take the Hindmost: a History of Financial Speculation.

Nervous financial markets and waves of fiscal austerity spreading across Europe raise an important question: when does a country’s budget deficit become a problem?

The easy answer, of course, is that a deficit is too large when it can no longer be financed. But by that time it’s too late, so it’s important to ask if there is a good way to tell before things get that bad.

Carmen Reinhart and Kenneth Rogoff, in a recent paper called Growth in a Time of Debt, found that when government debt reaches 90 percent of GDP, economic growth is seriously retarded.

But rules of thumb are by their nature imperfect, and it’s difficult to apply the 90 percent formula across the board. The U.S., for example, is not Greece—it’s closer to being the anti-Greece, in fact. Greece is a tiny, uncompetitive country that does not control its own currency. The business climate there is terrible. America is a vast, competitive, adaptable nation that not only controls its own monetary policy, but is blessed with the world’s reserve currency. The climate for business is favorable, abetted by large reserves of cultural and intellectual capital.

So we shouldn’t conclude that just because the Europeans are suddenly cutting public spending, we ought to as well. Since deflation looks more threatening than inflation, it seems sensible, for now at least, for America to borrow and spend. Washington’s cost of money is close to zero, and the multiplier effect (for which this blog is named) means that pumping funds into the economy is likely to pay growth dividends, especially if the money is directed at those likeliest to spend it.

Countries almost always run deficits and, despite the ardent wishes of fiscal conservatives, they probably always will. The problem, when debt accumulates, is that it can make you vulnerable to investors who may become impatient or even irrational. If these are the people who have the money you need to finance your deficit not in your own currency, you may find yourself in the position of several Eurozone countries now, who are forced to embrace austerity at the worst possible time. Perhaps the lesson is not to run up large deficits in good times, as Greece, Portugal, Spain and Ireland, so that in bad times you can get credit when you need it.

The Germans too are embarking on a fiscal austerity program, and consumers aren’t spending there either.

David Cameron, the new PM, warns that the nation’s fiscal hole is even deeper than it seemed, and that savage spending cuts will be required. An important union leader calls Cameron’s speech “a chilling attack on the public sector, public sector workers, the poor, the sick and the vulnerable.”

The full (and sobering) story is here.

As the European financial crisis continues to percolate, by now a few irreducible facts are distressingly clear:

First, Greece has no hope of repaying its debts as they are now constituted. Thus, the much-contested 110 billion euro bailout plan and the wider subsequent trillion-dollar bailout proferred by the Eurozone countries and the IMF are doomed to fail for the simple reason that they offer only more lending to countries already drowning in debt. Greece has a primary deficit (meaning one that would persist for a number of years unless the country experiences spectacular economic growth) exceeding 6% of GDP and a budget deficit due to financing of the accumulated debt of at least another 4%, in addition to which it faces a GDP contraction for at least three years. Simple math shows that to have a stable debt/GDP ratio Greece must generate a budget surplus of at least 10%, which is basically impossible. A rising debt/GDP ratio together with contracting economy will make financing from private investors very doubtful.

Second, although Greece can default on most of its public debt with a unilateral act of parliament—and the political and economic realities to do this may yet prove irresistible—it would be much better for Greece, the IMF and the rest of the Eurozone if it avoided this. For Greece to give up and default in this way would mean not just horrific economic pain for its citizens but the threat of financial turmoil across Europe and possibly the world, since many major banks are implicated. In addition, the debt of Spain, Portugal, Ireland and possibly Italy and even the United Kingdom would be severely compromised. These governments at the very least would face much higher borrowing costs, making their defaults that much more likely. Since investors know this, there might also be bank runs.

So what is to be done? Greece cannot default, but it can “restructure.” To contrarians this may resemble a default, but many people are capable of maintaining the distinction when it is in their interest to do so, as was the case with New York City in the 1970s. Basically, Greece needs more favorable credit terms—lower interest and longer to pay. The balance sheets of European and other banks holding the restructured Greek bonds to maturity will not be impaired absent mark-to-market accounting, which may be on its way out just in time. In this way, the banks can preserve the useful fiction that they are solvent, until they become so with the help of cheap money from the European Central Bank. Many of Greece’s current bondholders may not agree to this plan but the risk of default would be much, much lower with the restructured rather than the original bonds.

Any such restructuring must be done in conjunction with the IMF and EU so that Greece doesn’t become a financial pariah—or rather, so that Greece can cease to be one. The impact of such a plan would be large; Carl Weinberg of High Frequency Economics figures that restructuring the Greek bonds that mature between now and 2019 into a single self-amortizing 25-year bond at 4.5% would save the country more than 140 billion euros over the next five and a half years. The improvement in servicing the country’s debt together with the ongoing rebalancing of its public finances will revise its credit profile and enable access to loans from private markets.

Does all this sound far-fetched? It shouldn’t. All parties have good reason to work together on it, since there is no palatable alternative. Besides, such a restructuring has succeeded elsewhere, including New York City.