A day before S&P downgraded France, Spain, and Italy, I said that the euro crisis was easing. Did I make a fool of myself? I don't think so. The relatively successful Spanish and Italian bond auctions were encouraging (although Trisha Craig isn't so sure about the Italian case). French bonds have been trading at a premium for months, so the markets had already priced the downgrade in (mostly: French 10-yrs rose 10 basis points, from 3 to 3.1%, on the news). "Bad news but not a catastrophe," as François Baroin said in his characteristically subdued and mellifluous tone. (Is he as bored with the role of finance minister as he often appears to be? Or perhaps on tranquillizers? But I digress.)
Meanwhile, the Greek situation has worsened, and default seems almost inevitable. But Greece has been in de facto default for more than a year.
The big question now is how deep a recession will result from the austerity imposed by the ECB as the condition of its three-year repo promise--call it a bailout, quantitative easing, emergency rescue, whatever: the result is the same, namely, investors are now willing to hold the debt of troubled countries like Italy, Spain ... and, to an even greater extent, France, since there is an implicit ECB guarantee. This means that Europe might be able to muddle through, but only if the politics of austerity don't blow up in one of these countries, leading to a rejection of the euro deal or perhaps the EU altogether. It will be a close-run thing.
Does this mean that I've abandoned Paul Krugman in his tireless campaign against the Very Serious People who insist that the imposition of pain is the only way out of any crisis? No. I think we are far from adopting a first-best policy in Europe, but first-best seems out of the question, and second-best as well, barring a massive change of hearts and minds in Germany primarily but elsewhere as well. So let us hope that third-best will be good enough. As Mrs. Thatcher used to say, "There is no alternative."
Additional comment here.