One of the great topics of discussion with my in-laws over the holidays was the impending demise of the euro, and whether there was any hope for, or reason to, maintain the euro given the sovereign fiscal challenges of the member countries. The disastrous German and Italian bond auctions, and Spain’s cancellation of its sovereign bond auction, seems to portend “eurogeddon”. One of the articles that helped me interpret these events was this column from Jeremy Warner in the Telegraph:
No, what this is about is the markets starting to bet on what was previously a minority view – a complete collapse, or break-up, of the euro. Up until the past few days, it has remained just about possible to go along with the idea that ultimately Germany would bow to pressure and do whatever might be required to save the single currency.
The prevailing view was that the German Chancellor didn’t really mean what she was saying, or was only saying it to placate German voters. When finally she came to peer over the precipice, she would retreat from her hard line position and compromise. Self interest alone would force Germany to act.
But there comes a point in every crisis where the consensus suddenly shatters. That’s what has just occurred, and with good reason. In recent days, it has become plain as a pike staff that the lady’s not for turning.
In addition to the striking parallel images of Merkel and Thatcher as women who are heads of state fighting (almost too late) for fiscal responsibility, Warner’s column does a good job of pointing to the kind of market and policy movements we can expect in the next couple of weeks. Clearly many parties behaving responsibly have already laid out some contingency plans to mitigate the effects.
But I have a simple-minded question to ask, perhaps one that I should have asked two years ago: why are so many people so worried about contagion from sovereign default in the eurozone? Should they be worried?
Typically, interconnected financial markets have negative feedback loops that lead to the dampening of propagation; price changes as investors move money around in response to changes in relative risk are an example of such a negative feedback. But with so many policies designed to insulate, protect, bail out parties, policies that introduce asymmetries by insuring against losses, have these negative feedback loops been distorted and replaced or outweighed by positive feedback loops that amplify effects? That’s how I’ve been thinking about the bailouts and subsidies and loan guarantees in both the EU and the US — policies that distort the negative feedback effects that can be equilibrating and introduce asymmetries that create destructive positive feedback effects, whereas before any disequilibrating events or shocks could have been smaller and dampened by the normal negative feedback effects in markets. So I would normally say that the forces of self-organization exist to buffer and counter the forces of contagion, but the political rules in operation have stifled the forces of self-organization and exacerbated contagion.
One of those forces of self-organization and negative feedback is bankruptcy and default, both private and sovereign. I wonder if the EU will be able to activate the salutary re-equilibrating benefits of bankruptcy and default while simultaneously being able to either stem contagion or have the political fortitude to carry on through the pain and cost that is larger than it might have been otherwise.