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May 09, 2010

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Well, it's not 1931 any more?

The euro situation looks bad...for Europe, and for financial markets wherever. However, the world is now composed of nearly 200 independent countries, most of which have fairly activist central banks which have tools not widely considered 80 years ago, and Europe represents a much smaller percentage of global demand. So I don't see how Europe's crisis becomes the world's crisis without a lot of people screwing up.

So what am I missing?

I'm not sure that you're missing anything, just underestimating the risks.

(1) Hidden exposure. Consider how the collapse of the housing market in basically two states managed to sink the global economy in 2007-08. Well, defaults on Greek and Portuguese debt could have similar effects ... and a default on Spanish or Italian debt would be disasterous. U.S. institutions are highly exposed to European debt.

(2) Risk aversion, aka contagion. Markets don't really behave rationally. (This is why it is reasonable for conservatives to fear inflation --- even though I don't --- despite the fact that the markets show no sign of any coming down the pike.) Watching several OECD countries reschedule their debt could cause panicky investors to start diving for cover. After all, Spain is in fine shape ... the yield spike is clearly market overreaction. But such overreactions can be self-fulfilling, and when the bears are on the rampage it makes to get out yourself.

(3) The U.S. exports much more to Europe, as a % of GDP, than it did in 1929, let alone 1931. Moreover, U.S. companies now directly compete with European ones in most big export markets. In other words, a collapse in European demand combined with a big drop in the euro (and the resulting gains for European exporters) would be a bigger blow than back in the day.

Scared yet, David?

I should add that the easy way to deal with all of this is for the ECB to print a lot of money. (Of course, the southern countries would still need to liberalize their labor markets for that to have good effects.) But having a tool does not mean that it will be used.

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