Eurozone's 'doom loop' has gone into reverse, and may stick around for a bit

DURING the 2011-2012 euro crisis, the currency area became mired in a "doom loop", in which weak banks in financially distressed countries rationed credit, causing a recession that intensified pressure on government finances, which were already burdened by the need to cover banks' losses.

But such self-reinforcing spirals can also operate in the opposite direction. Understanding these dynamics may be the key to determining the eurozone's relative strength today.

In a doom loop, the expectations of default drive up risk premia until the economy reaches the brink of collapse, even if the underlying problems could be managed over time. At a certain point, when the gulf between financial-market pessimism and economic reality becomes too large, the market becomes ready for a reversal.