How to stop the European contagion

What’s at stake: This isn’t what was meant to happen. The Irish bailout was meant to stop and reverse the stress in European markets. Instead, the eurozone’s turmoil is spreading to Portugal and Spain, putting further pressure on policy makers as they grappled with decisions over emergency financial bailouts and the European Crisis Resolution Mechanism.

The market’s reaction to Ireland’s bailout

Mohamed El Erian worries that the contagion is spreading fast and that the levees put around Ireland do not preclude speculation from spreading. He posits that the rescue will be of little use if it covers large scale exodus or depositors and creditors. In his view, the crisis is just at its inception and clearly flags the risk that markets turn to Spain.

Felix Salmon writes that what the CDS tell us is that any bailout now only serves to make a future default more likely. The contrast from just a few months ago is striking: while the 1-year CDS showed the highest default probability back then, today it’s the lowest. The EU bailout of Ireland confirms that Portugal will probably not be allowed to default any time soon. But markets now consider a default is more likely 3 years out, and on from there.

Michael Schuman writes that the hope was that backing up Ireland would quell the contagion spreading to other weak Eurozone members, especially Portugal and Spain. But the opposite has happened. The fact that Ireland, considered a paragon of reform, was forced into a bailout has only solidified fears in financial markets that the others could be doomed as well. The strategy so far has been simple: Put up rescue funds, demand reforms in the weak economies and hope those steps rebuild confidence in financial markets that the Eurozone's struggling nations can pay back their giant debts. Europe's bailout strategy has failed because investors don't believe it is viable.

What to do now?

Paul Krugman writes that the European bailout basically short-circuits the vicious circle induced by higher interest rates. But the bailout will only work if the vicious circle is at the heart of the story — as opposed to being a symptom of the fundamental unsustainability of the austerity-and-full-repayment strategy. That is, it will work only if Ireland is the fundamentally sound victim of a self-fulfilling panic. And that’s a hard claim to make. If the problem is not essentially one of confidence and liquidity, Ireland (and Greece, and Portugal, and …) would need actual debt relief. Yet that is not on the table. Ireland, like Greece, is now insulated from the need to go to the market. But it still faces an enormous debt load, made worse by deflation and stagnation.

Michael Schuman writes that the entire bailout mechanism forged by the EU isn't tackling the roots of that crisis. What the Eurozone requires is a proactive effort to engage its problems in a more comprehensive way, helping the weaker members to resolve their debts and return to healthy growth, not just saddling them with further debt to prevent losses at European banks. In other post, Schuman argues that Germany and France can't just put up some cash for a bailout and go about their business. Germany, for example, should show a stronger commitment to reducing its current account surplus by liberalizing its still highly regulated economy to spur more domestic demand and buy more from the rest of Europe.

Emma Saunders argues that EU officials may have pressured Ireland to accept a bailout for nothing. High yields were surely not caused by Ireland’s lack of funds; otherwise we would have seen a big drop since Sunday. Yields spiked after Angela Merkel’s comments that bondholders might need to share the pain. Yields tempered after her comments were partly retracted. No other event – such as a bail-out agreement – has helped to calm the markets.

Jacob Funk Kirkegaard argues that what we are seeing with Spain is a largely speculative attack by the markets on the inability of current EU policy tools (EFSF/EFSM) to address Spain in the same way as Greece, Ireland and Portugal. Certainly, Spain faces serious economic growth and labour market challenges as it works its way through a devastating real estate collapse. But it has neither the debt stock of Greece, the bust banks of Ireland, nor the complacent government of Portugal. The case that economic fundamentals are behind the turmoil is missing. Instead, market concerns seem overwhelmingly speculative. Kirkegaard is confident that the EU can cope with such a threat as it functions best in crisis, and the political will to preserve the eurozone should not be underestimated.

Paul De Grauwe compares the possibility of debt restructuring to the possibility of devaluation during the Exchange Rate Mechanism (ERM) years. He argues that the proposed sovereign debt default mechanism for the eurozone introduces a similar incentive structure for speculators and national authorities as in the ERM. He concludes that a monetary union can only survive if there is a willingness to provide mutual financial assistance in times of crisis. The solution therefore is not to implement the sovereign debt default mechanism, which will lead to the demise of the eurozone, but to give a permanent character to the European Financial Stability Facility.

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