by internationalbanker

By John Manning – john.manning@internationalbanker.com

“The European Union is experiencing an existential crisis.” So began a plea for immediate action on the European debt crisis, co-signed by 14 economic heavyweights, including Thomas Piketty. Similar views have been expressed by Nobel prize-winning economists and top policy officials. The events unfolding in Europe are tragic not only due to the large-scale adverse ramifications felt by the European populace but also to the fact that much is already known and understood about the economics of debt and contagion, which could have mitigated if not prevented the current financial impasse that grips Europe.

Main Cover PhotoThe bailouts and concomitant interventions during the European sovereign debt crisis have been driven not only by worries of a financial contagion but also a fear of complete disintegration of the Eurozone, where exit from the euro might create a domino effect. This makes sense, since the large-scale financial-market integration across European nations makes the possible consequence of a default of one country so large that it threatens the very existence of the union.

Before we address the economics behind the “financial contagion”, it is informative to first understand the political backdrop of the Eurozone debt crisis; a crisis that is no longer purely “financial” in nature. It has given rise to populist movements that incite political extremism and exclusion. Political parties who were arguing for breaking up the Eurozone are no longer limited to the fringe.

The Eurozone is a truly unique arrangement in which the citizens of Europe, after years of war and strife, can now move freely across borders. Nevertheless, when things go wrong, it also means they can experience the discrepancy in living standards first-hand. When young talented graduates from Greece compete for employment in German bars, it is a clear sign that something has gone wrong. This has led to the dwindling of the faith left in the effectiveness of European Union (EU) institutions to safeguard and promote equal living standards as pledged upon its formation.

The situation in Greece, dubbed unceremoniously the “problem child of Europe” with huge racked-up debt (especially to Germany), provides a daunting task for European policymakers. The large amount of Greek debt is not only a policy failure of the Greek government but a scathing critique to the extent of the EU institutional failure in providing assistance to a new member in implementing required rules and fostering development. Instead of improved infrastructure and educational reforms proving a boost to the economy, Greece is the first developed country that experienced International Monetary Fund (IMF) default with concurrent collapse of a multi-billion-euro bailout.

All of this creates much tension and brings a distinct possibility of Greece’s exit from the EU in the upcoming referendum. The Greek prime minister’s idea of reintroducing Greece’s own currency is a distinct possibility and some commentators consider the “Grexit” inevitable (Economist, 2015).

The Greek problem has Eurozone members divided into two broad camps, with Germany representing the less popular lobby that has called for eviction of Greece from the Eurozone. On the other side of the spectrum lies France, which supports debt write-downs for Greece. The argument propounded by France is as follows: to expel a country in a dire economic situation is in stark contrast to the European ideals that gave rise to not only the Eurozone but also the European Coal and Steel Community (ECSC) in 1951.

It is a recurring pattern throughout Europe that when things go wrong, the immediate reaction is not to objectively ascertain the true cause of the problem but to quickly deflect it onto someone else. The European debt crisis problem is no different, in which the lack of resolve by leaders has given rise to populist movements directing their wrath on historically excluded groups and immigrants.

One stark example of the effectiveness of such exclusionary, populist movements emanating from the crisis can be understood in the backdrop of the rise of the anti-immigrant and anti-Islamic Dutch populist leader Geert Wilders and his far-right Freedom Party (PVV). Mr. Wilder’s party already enjoyed considerable support in both the Dutch and European parliaments before the crisis. His rhetoric of anti-immigration and breakup of the EU has been gaining ground not only in the Netherlands but also across Europe. Recent polls suggest he is poised to secure an even more powerful position in the Dutch parliament after the next elections.

All this is happening against the backdrop of another important political development: the upcoming referendum in the United Kingdom in 2017, which will decide whether the UK will remain an EU member or not. The announcement of referendum has already added strength to Mr. Wilders and other far-right parties across Europe and has made the threat of disintegration of the European Union more tangible. Nevertheless, many observers think the UK referendum, given its timing, is a strategic move by the Conservative Party to gain more leeway within the EU. The pressure on the EU has gained momentum, with British Prime Minister David Cameron also chiming in with his announcement to opt-out from any future EU laws and to cut welfare benefits available to migrants (BBC 2015).

Popular support against such policies is also gaining traction in the UK with recent polls revealing that only 45 percent of British citizens support the UK’s membership in the EU and believe the EU holds back the UK by setting restrictive laws and demanding high membership fees. While most politicians and big businesses still believe it is useful to be a member of the “family”, it is clear they will play hardball, and the future of the UK as a part of the EU is less than certain. More exclusionary pressures seem to be building up across Europe, with Scotland seeking independence from the UK and Catalonia from Spain and the EU.

Under this political background, we can seek to understand the economics behind the European debt crisis. Ever since the seminal contribution by University of Pennsylvania’s Franklin Allen and New York University’s Douglas Gale on the theory of debt crisis in the year 2000, the understanding of the equilibrium effects of financial contagion was greatly enhanced. They focused on the fact that banks need to hold interstate claims to provide insurance against idiosyncratic shocks in different countries. Moreover, they show that in the presence of uncertainty, the first best efficient outcome cannot be reached and optimal risk-sharing is not possible as conventional economic models would assume. The implications and conclusions of the model, which was written before the European monetary union came into full effect, was ahead of its time and showed how even a small shock in one country can quickly spread across the union with imperfect financial markets.

More recent theoretical developments have further deepened our understanding of financial contagion effects. This in turn can inform policy in Europe today. For example, subsequent scholars not only focused on the direct losses to creditors from a sovereign default (which is usually observable) but also indirect spillover effects. The indirect spillover effects arise from the impact of default in one country on credit riskiness of adjoining countries. This brings not only the empirical challenge of quantifying “across the region” credit riskiness and borrowing costs but also poses a modelling challenge since credit risk needs to be modelled as an endogenous process, in which it is determined jointly by highly financially integrated nation states.

For instance, Acemoglu et al. (2014) developed a model in which direct financial losses to lenders stemming from a default in one country (or even substantial loss of value) gives rise to a domino effect, where the lending sovereigns can experience large enough losses to bring them to the brink of an outright default. This contagion effect in the model is largely driven by the indirect mechanism that causes “bankruptcy” of one sovereign to introduce a cascade of bankruptcies through exceedingly high borrowing costs across the region.

The model is empirically evaluated by Glover and Shubik (2014) of Carnegie Mellon University and applied to study the financial contagion effects in the Eurozone, where credit risk perceptions arising from the spillover mechanism are explicitly taken into account. Drawing on a rich dataset from the IMF and the Bank for International Settlements (BIS), they quantify the sovereign debt holdings within the European economies. To assess the credit-risk perceptions or expectations of the European financial markets about borrowing costs, they use Credit Default Swap (CDS) spreads, in which the correlation of risk across countries is jointly determined by the amount of cross holding of sovereign debt. This allows for the quantification of contagion effects across Europe. For example, a simulation exercise of a Greek default shows that the first-quarter effect on other countries is not as large as political commentators and media had proclaimed, i.e., an increase of about 10 basis points. Nevertheless, the effect is not homogenously distributed across the union. For example, there is a distinct possibility of large-scale ramifications being felt by Ireland and Portugal. In the case of Portugal, a Greek default increases spreads by 60 basis points. This in turn implies an increase in probability of default for Portugal to be about 7.5 percent. Similarly, an increase in default probability for Ireland is estimated to be 5.3 percent as a result of a Greece default.

We should interpret the “rosy” picture painted by Glover and Shubik (2014) with caution. Firstly, the simulations are based on short-run forecasts, mostly limited to only the next quarter. It is plausible that the adverse consequences might take more than three months to fully materialize. Secondly, it would be a mistake to consider the adverse consequences of sovereign default to stem only from credit riskiness and borrowing costs. For example, substantial losses from a default can result from swings in risk aversion of lenders and borrowers, or vagaries of creditors’ perceptions about the probabilities of default in other sovereigns, which in turn could have a cumulative and potentially destabilizing effect across all of the region (Kodres and Pritsker, 2002; Arellano and Bai, 2013).

The latter critique with changes in risk aversion of lenders, vagaries of market or perhaps even structural changes in fundamentals is explored by Manasse and Zavalloni (2012), who exploit temporal variation in factor loading and market indexes in order to evaluate dynamics of common and idiosyncratic risks determinants across the European economies. Similar to the previous analysis, the authors exploit spreads in CDS. However, the (daily) frequency of their data allows them to isolate the idiosyncratic or individual component that does not co-vary with the market or the variation that is uncorrelated with “external factors”. This is achieved by observing the daily spikes in CDS that vary simultaneously across many countries, which the authors dub as the “pure contagion” effect. The effect is a result of “herd behaviour, a rise in risk aversion, agents’ coordination on a bad equilibrium” (Manasse and Zavalloni, 2012).

At this point, it is worth noting the distinctions and similarities of the impact on the European economy of the US subprime crisis vis-à-vis the European debt crisis. Although it is true that the effect of the financial crisis (originating with the collapse of Lehman Brothers in the United States) was experienced by all European economies, the magnitudes of the effects varied widely within Europe. For example, the US crisis affected the United Kingdom much more than it affected Austria. Still, the European debt crisis has been largely a Eurozone phenomenon. For instance, the Greek crisis had a large effect on the Netherlands, which is in the Eurozone, while it had no influence on non-members, as is the case with Sweden or the United Kingdom. Nevertheless, similar to the US subprime crisis, there is a wide variation in degree of impact, in which France, Italy and Portugal showed much greater market volatility and spikes in individual, specific risk relative to non-Eurozone counterparts, such as Sweden and Norway. This implies that the one-size-fits-all approach often propounded by the European Central Bank (ECB) and other European leadership might not be the best course forward to help resolve the crisis.

In this vein, the analysis of Manasse and Zavalloni (2012) is useful to understand what makes the country excessively responsive to the vagaries of the market and “market sentiment”. They show how (lagged) macroeconomic fundamentals explain more than 50 percent of all cross-country variation in idiosyncratic risk, where public debt/GDP and deficit/GDP ratios, unemployment, industrial production, market volatility indices proxy for economic fundamentals. This analysis is also particularly illuminative, since the asymmetric effects of crisis and non-crisis periods are demonstrated. For instance, it is documented that in periods of crisis, the financial markets respond more to economic fundamentals and structural variables, such as health of labour market, output capacity and productivity of the economy and public debt. This underscores the need to maintain a vibrant and dynamic economy that will be resilient to crises.

Reinhart and Trebesch (2014) take a more historical approach towards study of sovereign debts. In particular, they study lesser known, yet severe, debt crises arising as a result of World War 1 debt and its aftermath. The analysis is illustrative, since it involves analysis of huge debt relief by creditor nations (United States and United Kingdom) to allied Europe; the war-related debt owed to the United Kingdom and United States was defaulted by much of the allied forces in 1934. The amounts were staggering compared to today’s standards. For example, France’s debt write-off amounted to about 52 percent of its Gross Domestic Product (GDP), whereas Italy was given a debt relief of an amount equivalent to around 36 percent of its GDP. However, one should note that the international policy discussions leading up to the default of 1934 was reminiscent of the current European debt predicament, in which, during the early 1920s, the debt kept being rescheduled until the debt overhang was “resolved”. In the same period, Australia and New Zealand together with 15 European nations formally defaulted and suspended their debt payments to the United Kingdom and United States. This massive debt reduction through sovereign default is what helped these countries manage the inevitable debt-deflation spiral (as first propounded by Irving Fisher in 1933). The procedure involved a critical combination of devaluation and inflationary pressures providing the stabilization. The analysis of this study highlights that decisive restructuring of debts has growth-enhancing dividends, as it was reflected in the form of rapid economic acceleration in the post-war period. Furthermore, it also highlights that debt resolution involved supranational decisions and coordination, where 17 nations decided to postpone payments to the United States and United Kingdom.

This has clear policy implications for making the economy more resilient to shocks. For instance, the Reinhart and Trebesch (2014) study emphasizes that in the context of the current European crisis, the greater financial and nonfinancial integration relative to the post-World War 1 period calls for not only greater international coordination and caution, but also for a need to take “decisive” debt-restructuring that will take care of the debt crisis once and for all.

Furthermore, the Manasse and Zavalloni (2012) analysis implies that a larger emphasis is needed on growth, development and labour-market policies. This is contrary to the austerity policies implemented in much of the Eurozone, which contract the economy and therefore curb growth and employment, which has a negative feedback effect, exacerbating the debt crisis. The mechanism of action should not be based on the notion that economic downturns widen the deficits, but on the view that downturns are typically associated with lower productivity growth and employment rates, which worsens the economic fundamentals that play a critical role for economic resilience in crisis periods.

Another policy lesson that follows from this line of research is placing the focus on active labour-market policies and labour-market reforms that induce lowering of the unemployment rate and enhancing the skills of the labour force.

Based on both theoretical as well as empirical expositions, one is forced to reject the view that “multiple equilibria” (Manasse, 2012) arise due to random fluctuations or “sunspots” that are independent of economic fundamentals. If this was indeed the case, lagged economic fundamentals would not explain the cross-country variations in risk perception of the European economies, which is not the case. Therefore, a well-rounded policy response that might preclude the disintegration of the Eurozone would involve debt write-off, focus on investment, growth and active labour market policy.

Photo Attribution – © Photo by Gage Skidmore



The Financial Times article was cosigned by 26 of ‘great economic minds’, including two Nobel Laureates in Economics and a former prime minster of Italy.
Economist (2015), http://www.economist.com/news/leaders/21656662-whatever-its-outcome-greek-crisis-will-change-eu-ever-europes-future-greeces
BBC (2015), http://www.bbc.com/news/uk-politics-32810887
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