Europe: A BIG Problem

Lost in the pointless S&P downgrade debate is the fact that Europe is a HUGE problem.  And it's getting bigger.  For proof, take a look at what Italian 10-year bond yields are doing.  Also, Spanish 10-year bond yields.  In response, the European Central Bank has apparently decided to "intervene decisively on markets" once trading open tomorrow.  What that means, it's not fully clear.  If I had to guess, the European Central Bank is going to start buying up Spanish and Italian bonds.  Maybe both.  Why now? Well, the Eurozone can afford to bail out Greece, Ireland and Portugal indefinitely.  Greece's GDP is about $330 billion.  Ireland's and Portugal's are about $230 billion each.  Spain's is almost double those 3 combined.  Italy's is almost triple Greece, Ireland and Portugal combined.  The EU can't afford to bail either of them out.  Contagion to Spain or Italy would spell big trouble for the EU and the world economy.  In all likelihood, it would mean collapse of the Euro.  And that would be a massive problem.  Think Lehman Brothers times 1000.

So what will buying up Italy and Spain's bonds do? Well, for one, it will allow them to borrow.  And neither of their problems look anything like Greece's.  Whereas Greece had a massively distorted economy with a bloated public sector, along with a massive debt burden and a huge primary budget deficit, Italy has a big debt burden, but a primary budget surplus (meaning that, debt interest payments aside, its government actually takes in more than it pays out), while Spain had a fairly small debt burden and a primary budget surplus when its real estate bubble collapsed in 2008.  Capital market access would buy them time to improve their outlook while Greece gets its act together (and Ireland tries to pay down the debt the EU has shoved down their throats by forcing them to bail out their wildly irresponsible banks).  Realistically, it's not a way out as much as a stabilization mechanism meant to avert disaster.  But that disaster is scary enough that the ECB taking this action is without a doubt the right move.

The final question, I guess, is what contagion would mean.  My guess is a spiral in which Spain and Italy lose capital market access would end in a forced exit from the Euro for a number of countries (that or the ECB loosening monetary policy in a way that would be highly inflationary for Germany, which seems pretty unlikely...)-- Spain, Italy, Ireland, Greece, and Portugal are the obvious candidates.  Places like Estonia (which, Robert Samuelson nonsense pieces aside, is still suffering enormously; yes, 14% unemployment is down from 19% unemployment, which is better in the same way that losing a leg is worse than losing your head) would also probably have to go, and each of those places would suffer, as Barry Eichengreen detailed, the mother of all bank runs.  Confused? Well, here are the mechanics, as I understand them (as always, bear in mind that I'm no economist, so I'm probably prone to some misinterpretation).  An exit from the Eurozone would mean a massive global financial crisis.  The instant investors were told that the Eurozone would fall apart (or that a country was leaving the Eurozone), it would start a MASSIVE run on all of the country's banks.  The reason is that an exit from the Euro would mean redenominating the bank's assets in the new (old) domestic currency.  So instead of holding Euro-denominated assets, Italian banks would hold lira-denominated assets.  But remember that the lira would be revalued against the Euro, and this revaluation would mean the real value of the assets would fall.  So investors would scramble to transfer their assets from lira-denominated assets into Euro-denominated assets, and the Italian banking sector would collapse.  But the Italian banking sector has a HUGE number of counterparties, which in turn would see their assets and contracts evaporate.  As a result, the global financial system would seize up in a way that makes the crash after the Lehman collapse look like small potatoes.  And even a coordinated effort by global central banks might not be enough to push back against that kind of event.  Which is a scary, scary proposition.

(As a side note, the two best pieces I've read about this kind of problem, for anyone interested, are the Eichengreen piece I linked above and this paper by Maurice Obstfeld which talks specifically about devaluations in fixed-exchange rate regimes (like the ones in Argentina and Mexico), but default within a unified currency follows the same basic pattern.