UNTREATED, THE GREEK INFECTION NOW THREATENS EUROPE´S CORE / THE FINANCIAL TIMES COMMENT & ANALYSIS ( A MUST READ )

Untreated, the Greek infection now threatens Europe’s core

Mohamed El-Erian

October 5, 2011


Europeans, and with them the rest of the world, are discovering what all doctors know – a persistently misdiagnosed and incorrectly treated infection can eventually threaten even the healthiest part of the body, thus requiring more drastic medical intervention whose effectiveness is less assured.


This is what is happening in Europe today. A debt and growth crisis in the outer periphery of the eurozone (Greece) has been allowed to destabilise the inner periphery and the outer core (Ireland, Italy, Portugal and Spain). In addition, signs of dislocations are now visible in the inner core – both through the banking system and directly.


In the last few weeks, European banks have come under increasing market pressure. In one case, that of Dexia, governments are being forced to counter worrisome fragility. Moreover, as recognised by policymakers, a banking system that previously was just on the receiving end of the sovereign debt crisis (because of large holdings of peripheral debt) now risks becoming a standalone source of disruptions – multiplying the policy challenges.


Stress is no longer limited to the continent. Reflecting the high interconnectivity of global banking, some American institutions have also come under pressure as contagion concerns amplify the detrimental impact of an economic slowdown and structural weaknesses that persist three years after the last global financial crisis.


Also interesting, and less noticed, is what is happening in a still-obscure market segment that sheds light on sovereign credit risk, albeit imperfectly. There, spreads on German credit default swap have quietly widened to around 120 basis points in the last few days.


Such previously unthinkable levels are fundamentally inconsistent with Germany’s very strong sovereign balance sheet and its impressive record of successful multi-year economic reforms. Admittedly, the situation is mainly a reflection of bank-related counterparty risk issues and imperfect portfolio hedging. Yet, at around twice the US level, the CDS spreads may also speak to market uncertainties regarding the size of the contingent liabilities that Germany could face on account of the eurozone crisis.


By defining a new stage in the crisis, these developments undermine a regional policy approach built on the presumption that the inner core of the eurozone – sovereigns with rock solid balance sheets and their banks – can help pull up those in the struggling rest committed to put their domestic house in order.


The priority now is to urgently reestablish this presumption, and do so in a decisive manner. To this end, Europe should move immediately on three mutually-reinforcing fronts whose impact can be reinforced by appropriate policy actions in America and the emerging world:


First, Europe needs more effective circuit breakers to stabilise the banking system. In some cases, this would require immediate equity injections and a broader range of emergency liquidity facilities. It is encouraging that European Union ministers were reported last night to be looking at bank aid plans.


Success here is closely linked to the second issue that materially impacts the asset quality of banks balance sheets – the paramount importance of a more refined and effective approach towards the peripheral sovereign debt crisis.


Europe needs to differentiate more definitively between countries whose main problem is high and volatile interest rates, such as Spain, and those where underlying solvency issues require immediate debt reduction, such as Greece. The latter implies a reformulation of the program supported by the Troika (European Central Bank, International Monetary Fund and EU) to incorporate realistic fiscal and privatisation components and a more aggressive private sector involvement.


Third, Europe should decide what it wants to look like in the future, and press forward on related structural and institutional reforms. As the largest actual and potential financier, Germany would need to choose between two corner solutions: a politically-driven, but costly, fiscal union involving the current membership (conceptually similar to what West Germany did with East Germany twenty years ago). Or a smaller, less imperfect and thus stronger eurozone, but one involving tricky transitional aspects.


Many around the world have witnessed the deepening crisis with a mix of astonishment, concern and, now, fear. Those who already rang the alarm in the hope of spurring effective policy actions are being joined by others who previously refrained from doing so due to worries that the alarm could, instead, contribute to policy paralysis. In the context of European actions on three fronts, all could contribute to containing a crisis that also risks to seriously undermine global economic growth, jobs, financial stability and social cohesion.
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The writer is the chief executive and co-chief investment officer of Pimco