The four sources of contagion in the Euro Area

2011-10-15

This post is archived. Opinions expressed herein may no longer represent my current views. Links, images and other media might not work as intended. Information may be out of date. For further questions contact me.

By the word “contagion” we mean the transmission of the economic crisis from one part of the Euro area, to another. As I am currently writing this, contagion in the euro area has already reached the core and has seriously contaminated Italy, Spain, Belgium and major European banks that have for long now been verging on insolvency. The crisis in the euro area is systemic as I have always said, yet if a system-wide approach was devised from the very beginning then there would be no contagion and the crisis would have been tackled in its early stages with much less cost both in terms of human suffering and in terms of money and time (see Full Analysis of the Euro Crisis). The crisis has now spread from the weakest parts of the euro area to the strongest due to four main reasons: (1) the interconnection of the economies of euro member-states, (2) the systemic flaws of the euro architecture that lacks the necessary stabilizing tools and a unified banking sector, (3) the underlining insolvency of European banks that was never addressed, (4) the toxic structure of the mechanism that intended to solve the crisis, the EFSF.

The interconnected of Euro member states is realized in three ways: First, there is intense trade between the states, thus a loss of one will also imply a loss of the other (see Evaluation of inflation and unemployment amid the Euro Crisis). Second, private banks have heavily invested in sovereign bonds of Euro states and would be seriously affected in case a single state is unable to pay them back (see Can a 50% haircut save Greece? Can it save the euro?). Third, because the euro is above all a project with political ends, which implies that all members are partners that will come to the need of those in trouble. Hence an inability to provide assistance to any partner state can be seen as a political failure (see The crisis of the Euro is deeply Political). Euro member-states are like a group of climbers that are tied together, where if one falls, all fall down together (see Currency union and Greek Euro Exit).

Coming to the structural flaws of the euro I have already covered the issue in depth in a previous analysis of the Euro Crisis (see Full Analysis of the Euro Crisis). For the sake of reminding you about the general aspects of the matter here is what I wrote (for details see the analysis):

The euro as it was designed was nothing more than the first stage towards a genuine monetary union that presupposes apart from the free movement of goods, persons, services and capital (the Four Freedoms), the political willingness and the common vision; two other fundamentally important elements: Namely a fiscal union and a unified banking sector. </p> For as long as politicians do not have the necessary tools/mechanisms to combat the crisis, then there can be no end to the cost. As such the architectural flaws of the single currency need to covered either by using in a creative way existing institutions or by devising new ones (though the latter can be time-consuming and thus might not be ideal).

Moving on to the third source of contagion, about the underlining insolvency of European banks, I have been stressing for months now, that private banks were deep in the hole despite what the stress tests showed and regardless of what politicians said. Dexia passed the test in July with flying colors, but was recently proven practically bankrupt, thus proving me correct and showing how derisory the tests were. European banks had over-borrowed prior to the 2007+ crash and leverage ratios where as high as 50/1 or even 60/1 (Deutsche Bank for instance had a debt that was as high as 80% of Germany’s GDP!!!). All this toxic waste stayed in their books and was never cleansed by a central plan, as was the case in the United States through TARP (Troubled Asset Relief Programme). Hence today we have the discussion of (again) recapitalizing private banks to prevent a financial meltdown that will bring the whole world into another deep recession.

Finally the fourth source of contagion is the EFSF itself. It is a terrible mechanism despite the fact that it has been created with the most sincere intentions. As it is currently structured, it resembles a huge CDO (Collateralized Debt Obligations – the sort of financial derivatives that caused the Great Recession in the first place) right at the heart of Europe. It comprises slices of debt each with a different credit rating that all together constitute a AAA rated body. The problem with that is that such a structure is toxic for it depends on the guarantees of its member-states, in other words it increases their debts so as to have funds. For as long as the triple-A rated countries cling to their excellent credit rating the EFSF will remain triple-A rated itself. But if France loses its current credit rating, which is quite possible if it has to recapitalize its gravely exposed private banks, then the burdens will all fall on Germany, which suggests that the mechanism can easily fall into jeopardy, taking down with it the programmes in Ireland and Portugal. The problem now with the EFSF is the following: at its current funding capacity and with the new powers it was granted in the July 21 Summit, it has been overstretched and is practically unable to either contain the shock wave of a Greek default/restructuring or provide a backstop to the fall of Italy, Spain and possibly Belgium (see The ECB captivity and the Italian, Spanish and Belgian prisoners). If it stays in its current form, it is useless, if it is provided with further funding it becomes even more toxic, thus even more volatile.

With all these in mind, it becomes clear that contagion can no longer be contained and even if it could, that would not come from the sort of “firewalls” that some politicians promise, as if those would derive at no cost. To build firewalls you need to address all of the above, and this cannot be done with the kind of half-measures that many are putting forward. The crisis can only be killed off with a coherent system-wide strategy that will take into account all of the sources of contagion.