Europe is having problems again. This time, the problemshave different roots than in 2010 and 2011. For the past two years,investors have feared a contagion of default, triggered by a lossof liquidity and a panic among bankers and other bond investors,something akin to what happened in the United States during thesubprime crisis. The European Central Bank's decision, late lastyear, to pour liquidity into markets has largely, if notcompletely, relieved such concerns. The more recent investor fearshave attached themselves to the continent's seemingly single-mindedemphasis on fiscal austerity. Because such policies threaten toimpose a vicious cycle on weaker nations, one in which budgetrestraint retards growth, creating still larger deficits that forcestill more restraint, investors have begun to wonder if thesenations can ever reach solvency. The ECB cannot help in thisregard. To answer these fears, Europe needs to develop a growthagenda to parallel its otherwise essential austerity measures.

The recession into which Europe already seems to have sunkoffers a grim background for such concerns and considerations.Recent reports show unemployment in the eurozone approaching 11% ofthe workforce, even in the so-called stronger countries of thenorth. Spain records five million registered unemployed,almost 15% of the country's working-age population. Industrialproduction has contracted across the continent, even in thesupposedly more vibrant north. Official forecasts call for realgross domestic product to fall more than 4% this year in Greece, 1%in both Italy and Spain, and 3.5% in Portugal. And these figuressurely carry the optimistic biases of all official forecasts.

This unattractive picture is partly an unavoidable legacy ofpast financial problems. Recurrent liquidity crises in 2010 and2011 undermined the capital adequacy of European banks and bredfear among bankers about the credit quality of other financialinstitutions as well as borrowers generally. Their consequentcaution has rendered Europe's financial system incapable of fullysupporting robust economic activity. The strain shows in all ratespreads, in those paid by sovereign credits, of course, but also ininterbank lending and in the rates paid by corporate issuers. Evenas the ECB creates large dollops of additional liquidity, thebanks' need to rebuild their capital bases continues to retardlending, force asset sales and generally constrain liquidity. Itwill for some time to come.

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