Thursday 22 February 2018

Contamination not contagion the more urgent problem for euro zone

Gary O'Callaghan

The word "contagion" has been used a lot during the euro crisis. It reflects a fear that adverse developments in one eurozone country will damage another and lead to a cascade of problems.

The crisis has unfolded in a manner consistent with the notion of contagion -- Greece succumbed to market pressures and accepted an IMF/EU package one year ago; Ireland followed six months later; and Portugal has now been forced to take the same leap. There are still concerns that Spain or Italy will be next.

We became very familiar with the notion of contagion during the financial crisis in the United States when it seemed that one bank or financial institution after another could collapse and bring a faltering and related institution down with it in a domino effect.

These large financial houses were associated in two main ways. Firstly, they made similar mistakes and the demise of one pointed to weakness in others. Secondly, and more directly, they owed substantial amounts of money to one another and the demise of one would leave a hole in the balance sheets of others.

In such circumstances, it became necessary to quickly use large sums of public money in support of private institutions and prevent a collapse of the entire financial system. This was accomplished.

But there is a difference between what happened in the US and what is going on in the eurozone. The countries that are still in crisis are not closely related in either of these ways.

In the first place, they have not made common mistakes: Greece has a fiscal problem; Ireland has a bank problem; and Portugal has a problem with competitiveness.

And the financial links between these countries are also quite modest. Yes, Portuguese banks have significant exposure to Ireland but, beyond that, the connections between these three countries are small.

Ireland, for example, does not have any significant exposure to Greek debt.

So "contagion" might not be the best term to describe the evolving relationship between these countries. In fact, the main connection between all three countries is their common exposure to the same eurozone attempt to resolve the crisis.

This approach is based on:

  • Rejecting default or reduction in the debts of other creditors -- such as senior bondholders -- in order to isolate the core countries from a genuine threat of contagion from the periphery.
  • Forcing the countries on the periphery to make the maximum effort to resolve their "own" problems -- including misguided attempts to have Ireland raise its corporate tax rate.
  • Providing the minimum of financial assistance at penal rates -- precluding, for example, a commitment to medium-term ECB funding for banks.

This reluctant approach is failing and the main connection between the affected countries is better described as "contamination" rather than contagion.

The recovery programmes are being undermined by exposure to the eurozone's toxic approach to the crisis.

Their common problem is demonstrated in the way that interest rates on the debts of these three countries move in tandem -- inexorably upwards, it would seem, reflecting a waning of market confidence in any resolution.

But their contamination is felt even more acutely in negative feedback loops between their efforts at reform.

A problem that emerges in one country worsens the overall crisis, and renders the joint response even more inadequate, thereby undermining the chances of success for the other countries involved.

If Greece fails to meet a fiscal target, for example, chances increase that the whole approach will fail and another deposit leaves the Irish banking system.

The reform efforts are each contaminated by any weakness in the others because the overall approach is not big enough. And this factor, in turn, introduces weakness in all.

That is why the IMF pleaded last week for a more comprehensive European response to the crisis. It noted that the Irish programme was in danger of failing -- not because of a lack of commitment at home, but due to a lack of commitment and other spillover effects from abroad.

Instead of the existing -- and grudging -- approach to resolving the crisis, reform programmes need to be comprehensive and big-hearted if they are to avoid the pernicious consequences of contamination.

But big hearts are rarely found in Europe these days. A proposal by the president of the Eurogroup Jean-Claude Juncker was recently described as "devastating" and "catastrophic" by ECB board members and the ECB president Jean-Claude Trichet walked out of a meeting.

German Chancellor Angela Merkel was joined by others in warning southern Europeans that they had to work harder and play less while, in fact, according to the OECD, Greece has the same average retirement age and number of official holidays as Germany.

And this unseemly bickering only encouraged public demonstrations that have spread to Spain.

There is a genuine fear of financial contagion from the periphery into the core -- because the periphery is getting bigger and will have a larger financial impact on any core country -- but it cannot be contained with half-hearted measures.

Moreover, the ongoing contamination of our reforming economies from a failing approach to the crisis has not been recognised in Europe and will, ultimately, undermine any attempts to contain genuine contagion.

Perhaps the first lady at the head of the IMF, current frontrunner Christine Lagarde, would be able to explain the value of a big heart.

Gary O'Callaghan is Professor of Economics at Dubrovnik International University. He was a member of the staff of the IMF and has advised numerous governments on macroeconomic policies.

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