Blog Post

Playing the blame game: contagion edition

What’s at stake: Until now, Europe has managed to keep Spain and Italy – the third largest bond market in the world – out of the eye of the storm. After an epic week, this is no longer the case. As the policy response is gradually moving from providing liquidity to raising genuine solvency question, […]

By: Date: July 11, 2011 Topic: European Macroeconomics & Governance

What’s at stake: Until now, Europe has managed to keep Spain and Italy – the third largest bond market in the world – out of the eye of the storm. After an epic week, this is no longer the case. As the policy response is gradually moving from providing liquidity to raising genuine solvency question, financial markets are panicking. We round up here the usual suspects for such a failure: speculation, ratings agencies and policymakers’ complacency at the domestic and European level.

No, Greece is not Italy

Mario Monti writes that it is, to a certain extent, surprising that the eurozone crisis is now finally knocking on Italy’s door. Unlike Greece, Italy has gradually brought its deficit under control in recent years. Unlike Ireland, Italian banks have been only moderately affected by the crisis. Unlike Spain, Italy had not been characterized by an over expansion in either construction or private sector indebtedness.

Patrick Jenkins
writes that the market is focused on one data point more than any other at the moment: the 120 per cent gross debt-to-gross domestic product ratio the country is expected to show this year, according to the International Monetary Fund though stable, is too close for comfort to Greece’s 150 per cent. It is way more than the 64 per cent in Spain, about which there has been far more investor concern up to now.

“Crunch time” has arrived

Buttonwood points that that the 60 basis point widening in spreads between Italian and German bonds on Monday was a phenomenal move for the world’s third largest bond market. this is exactly where the European authorities didn’t want to be. The rescues of Greece, Ireland and Portugal were all designed to buy time and prevent contagion spreading to Italy and Spain. There is a sense that the markets are moving faster than the authorities can keep up; one can find parallels with the ERM crisis of 1992.

Ryan Avent
all along, it has been clear that sovereign-debt troubles in Greece, Ireland, and Portugal were primarily a political challenge, rather than an economic challenge, for the euro zone as a whole. Insolvency was and remains a serious issue for these smaller peripheral economies, but because they’re small there was no question of Europe’s ability to handle the mess, only a question of how costs might be shared. There was a risk, however, that a badly mismanaged effort to deal with the debt mess in these small countries could shake market confidence in the debt of other and larger economies, most notably Spain and Italy. If Spain were plunged into a Greek-like situation, the fiscal math of the crisis would suddenly grow much more difficult. For Italy, the situation is even worse as sovereign and bank exposures to Italian debt are far larger than are exposures to the debts of any other troubled country. If there have been fears that a Greek default might require a new round of bank recapitalisations, well, one shudders to think of the impact on banks of an Italian restructuring.

Playing the blame game: the eurozone cacophony

Real Time Brussels notes that after months of senior European officials making demands on Irish politicians and chastising Greek and Portuguese ones, the roles have reversed in recent days, with Brussels, Paris and Berlin now taking the flak from the so-called peripheral euro countries for failing to get their act together quickly. On Wednesday, Irish leader Enda Kenny said there was “no point” attending a possible meeting of European Union leaders on Friday if the group failed to make any decisions to solve the crisis.

Charlemagne
writes that one can understand the anger of George Papandreou for being mad at eurozone leaders. He has faced down riots, mass protests and party rebellion to push through a second austerity and reform package. But a second bail-out from the euro zone that was supposed to tide Greece over until 2014 has yet to materialise (although it did get a €12 billion ($17 billion) tranche of loans to keep going until September). Tuesday’s euro-zone statement was filled with promises of action, but the details remain slippery. Indecision is causing contagion; contagion is affecting bigger countries, like Italy. And the contagion of Italy threatens to ravage the entire euro zone, including Greece.

Playing the blame game: the Italian political comedy

Mario Monti writes if Italy – and not Spain – has been chosen as the target it is probably because of the recent intensification of belligerence within Prime Minister Silvio Berlusconi’s government. Even if these moves against Italy are not wholly justified by fundamentals, the pronouncements by rating agencies and markets have triggered a sense of urgency reminiscent of days in which Italy regularly found itself in financial difficulties before the launch of the euro.

Paola Sapienza and Luigi Zingales
blame Silvio’s antics for Italy’s bond market fall. The recent corruption scandals have simply induced a revision of the level of investors’ trust in the country. Last winter, the commissioned a survey of US citizens, to analyse the effect Mr Berlusconi’s extravagant personal life had had on Americans’ trust towards Italians in general, and their willingness to buy Italian products in particular. It might seem far-fetched to think that the infelicities of a leader could cast a shadow on his nation. Yet their research suggests that they have done so. A correlation between knowledge of Mr Berlusconi’s indictment and trust toward Italians in general could have been affected by other factors.

Playing the blame game: the ratings agency

Shane Fitzgerald of the institute of international and European affairs writes that the rhetoric against CRAs has ratcheted up. Commission President Barroso called the decision to downgrade Ireland "incomprehensible". Der Speigel reports European Justice Commissioner Viviane Reding as saying that "Europe can’t allow three private US enterprises to destroy the euro". German Finance Minister Wolfgang Schäuble asks whether "the oligopoly of the rating agencies can be broken up".

Peadar o Broin
also of the institute has a nice table compiling the repeated long-term sovereign ratings downgrades for Greece, Ireland, Portugal and Spain and further details on the regulatory reforms currently discussed.

Eurointelligence
reports that EU competition commissioner Michel Barnier wants to prohibit ratings for countries which are part of an EFSF rescue program. In a speech in Paris he argued that they enjoyed European solidarity and that they were under the watch of the EU and the IMF. Barnier said that a downgrade “weakens states and there is a potential of contagion to other states”. Barnier asked the Polish EU presidency to put the topic on the agenda of the next finance minister’s meeting.

Wolfgang Münchau
argues that the rating agencies, for once, have done the eurozone a favor by downgrading Portugal, and effectively killing the French debt rollover proposal. Portugal will need a second loan at some point. If the eurozone forced Greece into a default, the rating agencies are right to assume that the private sector will also be bailed-in once the second loan programme to Portugal is negotiated. The selective default rating by Greece will then trigger a selective default rating of Portugal and Ireland (and Italy it now seems as well.)

A note of optimism: if that’s what it takes

Jacob Funk Kirkegaard argues that market pressure can force EU leaders to compromise. Regional integration has historically been forged in such financial crises, though fortunately Europe has moved beyond wars to provide that sort of threat. Against the odds, however, there is reason to be optimistic that a political response can be agreed that will quickly allow both Spanish and Italian bonds yields to drop back down. Both Italy and Spain have sounder economic fundamentals than the three small peripheral countries. There is no reason to believe that the six percent ten-year rate represents a irreversible "credibility watershed" for either country. Recent market contagion to Spain and Italy may therefore once again have forced EU policymakers’ hands and beneficially expedited their necessary compromises. It certainly would not end the Greek debt crisis or restore the country to solvency. But it could rein in contagion. As always, in European crises, the absence of alternatives clears policymakers’ minds marvelously.

Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.


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