There are three types of contagion in a financial crisis, when the potential collapse of a firm, bank or country threatens to spiral out of control. The European Union today has all three.
The first type is purely psychological -- the panic of herd behavior. The second comes from thinking through the real effects that a collapse would have, as the potential spillovers dawn on people. The third, and most devastating, emerges when smart investors realize that their assumptions -- based on the pronouncements of policy makers -- are all wrong and need to be tossed overboard.
A common characteristic of the panic phase is that the bottom drops out of economic forecasts, taking with them the perceived ability of companies or countries to pay their debts. The corollary of this is that estimates of losses soar to once-unimagined levels. Some analysts now suggest that Greece might have to impose a haircut -- or loss -- of as much as 80 percent on creditors. This is up dramatically from the recent market view that 40 percent losses might be needed in a restructuring.
Emotions are taking over and the abyss looks bottomless, as it did for Russia in 1998 or Argentina in 2002. Countries, unlike companies, don’t go out of business. But in its panic, the herd tends to forget that.
Typically, in the second type of contagion, the spillover crosses borders because of trade. In the early 1930s, for example, major countries adopted fiscal policies that reduced their demand for other nations’ exports and pushed them toward recession. Some of this spillover also happened during the financial crisis of late 2008, when shrinking demand in the U.S. and Europe rippled through to Asia. Fortunately, most Asian countries were well prepared; their governments had modest debt and didn’t need to turn to fiscal austerity to meet their obligations.
While Greece, Ireland and Portugal play only a modest role in trade within the EU, they are tied into the EU’s financial and banking system. This is reminiscent of what we saw in Asia during 1997-1998. As international banks experienced or expected losses in Thailand after its currency devaluation, they became more cautious about lending to Malaysia and Indonesia. This restricted credit, pushed up interest rates and stifled the commercial paper market, an important source of funding for Indonesian corporate debt. It’s worth noting that financial linkages are more extensive within the EU today than they were across Asia during 1997-1998.
The third type of contagion is the scariest. When investors start believing that an important set of people have changed their minds about providing support to troubled firms or countries, a lot of assets need to be repriced.
This is the most plausible explanation of what happened after the collapse of Lehman Brothers Holdings Inc. and the near-failure of American International Group Inc. in September 2008. When the Federal Reserve made a loan to AIG that took priority over other creditors, the value of AIG’s senior debt fell 40 percent. The implication was clear: Morgan Stanley, Merrill Lynch and Goldman Sachs could either go the Lehman way or the AIG way. The same was true of money market mutual funds. It was time to get out.
The Germans now want to end the moral hazard of lending to weak euro-zone governments and banks, thus encouraging the belief that richer and better-run countries will provide the necessary support to prevent creditor losses. The trouble is, if you think that the problems are deeper, and that countries with independent fiscal policies can’t co-exist with a common currency, then Germany and other fiscally conservative nations will have to bail out their weaker neighbors again.
Persuading the EU
This isn’t about the policy preferences of the International Monetary Fund, the U.S. or the Group of 20. This is about what Germany is willing to do and what it can persuade its EU partners to go along with. Ultimately, German politicians can throw up their hands and say, bluntly: If you don’t like our proposals, you can do something else, but pay for it yourself.
Either way, the result is increasing risk of a debt default and losses for creditors. We’ll see the consequences as interest rates for troubled countries rise and the liquidity in their government bond markets dries up.
Exiting the moral hazard trade is a good idea. But there is no transition plan -- just a series of improvisations, gut reactions and continual renegotiations. There isn’t yet anything close to the political will to definitively end things with a comprehensive solution that tells you who will restructure and who will get unlimited bailouts. This contagion will spread, until senior euro-zone leadership decides -- once and for all -- who is to be saved and on what terms.
(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a Massachusetts Institute of Technology professor and a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)
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