Monday, April 26, 2010

Can contagion in Europe be avoided?

Good post by Felix Salmon here.  The outlook for Greece is indeed depressing. But it's not just for Greece.  What keeps me puzzled is why does anyone think that bailing out Greece and avoiding Greek default make the situation in Portugal and Spain any easier? Consider:

1. If a mere promise of a bailout along the lines of "we will not let a Euro member fail and here is a nice chunk of change in committments to prove it" worked, Greece would already be safe and be able to fund itself in the market. To put it in H. Paulson's terms, they already brought out the bazooka, but it's been mostly ineffective - though probably because the use of bazooka still needs to secure political approval and because caliber is too small.

2. Even if they bring out an unlimited-caliber bazooka for Greece (i.e. Germany somehow agrees to an open ended funding committment), why would that make anyone think that a blank check is waiting for Portugal, Spain and Italy as well, if those three ever need it? It's not like France and Germany have unlimited appetite for bailing out their neighbors, right? Politically, pushing any bailout after the Greek one is going to be much more difficult (go on, try selling another bank bailout to the American public today), so a bailout for Greece means that Portugal is actually LESS likely to be bailed out. Meaning that if Greece is fully contained, Portugal is definitely next up for bond vigilantes.

The key difference to TARP here is that Germany and France have to consider bailouts in succession, while TARP (plus emergency lending by the Fed) was a blanket promise big enough in size to cover all of the major US banks, all at the same time.  The latter requires one-shot political agreement - which is difficult but possible in sufficiently dire circumstances. The former is virtually impossible -- it's political suicide, even if the eventual economic outcome is the same. So the only way to avoid contagion that I see, would be for Germany and France to agree to a creation of an pan-European treasury, fund it with, say, 500 billion of seed capital and authorize it to issue its own bonds backed by full faith and credit of all EMU members. In other words, they need to replicate the federal system.

1 comment:

  1. "so a bailout for Greece means that Portugal is actually LESS likely to be bailed out": exactly. This is what most commentators are missing and what makes the situation so troublesome. And now could please someone tell me who is dishing out all these CDS on Greek bonds to whom? Or - to put it the other way round: Who is going bankrupt in the case of a Greek default because he sold CDS but cannot meet his obligations?