Does a European fire break exist?

By Felix Salmon
May 24, 2010
Mohamed El-Erian had one of his most explicitly bearish op-eds yet in the WSJ this weekend, saying that "the unwind of unstable investor positions is still in its early stages". But he also talked a little about the necessary policy responses which have yet to be seen in Europe:

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Mohamed El-Erian had one of his most explicitly bearish op-eds yet in the WSJ this weekend, saying that “the unwind of unstable investor positions is still in its early stages”. But he also talked a little about the necessary policy responses which have yet to be seen in Europe:

Are appropriate circuit breakers being put in place to limit the collateral damage for European growth and the global economy more broadly? …

The emphasis on circuit breakers is there, but badly targeted. Rather than focus on a defensible and sustainable fire break, too much effort and money are being deployed to defend the indefensible, like Greek over-indebtedness.

I’m skeptical that “a defensible and sustainable fire break” exists even in theory, let alone that it can be implemented in practice. Fire breaks work by isolating problem areas and preventing them from infecting the broader neighborhood. But the global financial system is far too complex and interconnected for any problem area to be isolated: as Rick Bookstaber has shown, correlations can and will appear from nowhere the minute a crisis erupts.

A fire break would, realistically, take one of two forms. Either it would be a bit like a real-world fire break, where you let Greece go down in flames but put lots of resources towards stopping the flames from spreading. I suppose the example here is Lehman Brothers: its collapse was so disastrous that it rapidly became obvious that the government would let no other large financial institution fail in Lehman’s wake. But that was hardly the message that Hank Paulson and the rest of the government wanted to send; they had hoped that letting Lehman fail would be the death of moral hazard and too-big-to-fail, rather than its rebirth. Certainly it’s hard to envisage a scenario where Greece’s collapse reduces the perception of the degree of risk in the rest of Europe.

So then there’s the other kind of fire break, where you burn down a bunch of Greek debt, causing short-term pain for Greece’s creditors, in order to make the sovereign finances more sustainable over the long term. The technical word for that is “default” — which is a lot more drastic than one might normally consider “appropriate circuit breakers” to be. And it, too, is prone to spreading uncontrollably.

This is why Europe is defending the indefensible: because failure to do so means a very high chance of chaos. Maybe once markets have sold off further, that kind of chaos might be more priced in. But for the time being, the indefensible is being defended just because the markets still seem to have faith in it and governments are hopeful they’ll be able to avoid a replay of the period between September 2008 and March 2009. The problem, of course, is that they don’t have a real plan for achieving that.


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greek government has launched a very severe austerity plan combined with a sincere and effective war against tax evasion and black economy(almost 40% of gdp).Greece will not default and will be soon an extremely positive surprise worldwidely.

Posted by dinos | Report as abusive

I totally agree.

Posted by panosp | Report as abusive

I totaly dont agree!

Posted by Wicki | Report as abusive

Why do these Greek commenters never end their comments by saying “and I am filling my boots with high yielding Greek debt”? 8% for a sovereign that won’t default sounds like a pretty good yield to me, if you believe anything you’re saying.

Posted by johnhhaskell | Report as abusive

At some point these politicians will have to take on publicly Mohamed El-Erian to spell out what does he think the solution is. So far what we know is he is asking for Greece default. That is just one piece. So say German and French banks have exposure to Greece bonds and let us say ECB compensates these bank. So you are on one hand having a sovereign default and on the other hand European Bank bailout. Does that get any worse? Even if all of the current politicians are defeated in elections and replaced by a new batch; having done these 2 things (sovereign default and European bank bailout); is Europe’s problem going to get solved?

Further when politicians undertake public dressing down of Mohamed El-Erian, they can keep asking “and while you are advising how to untangle this mess, will you please let us know how those prescribed moves will help PIMCO?”. You see the problem – both for El-Erian and Establishment?

I am not doubting sincerity of El-Erian. But at some point this ‘criticism while sitting on fence’ either got to be fully internalized by ECB without going public or need to be shut up. Else it is really counter productive collectively.

If we think Mohamed El-Erian is such a smart pant, then why is he not in the room with ECB folks? Granted, politicians would hate that since they are on the hook ultimately, but what good it is he staying out of the room and crowing about all this? Public has an interest in bringing all these so called smart folks together to address the problem collectively. Else we will be paying the price via ‘double dip’.

This generally does not happen with war. Only retired Generals can comment about that as there are no ‘private parties’ in many cases unlike economic crisis situation.

Posted by umeshgeeta | Report as abusive

A firebreak would be for Germany to leave the Euro and become Germany again. The reason Sarkozy fought so hard for Greece is because France and Greece are comrades in socialist decline. France’s ridiculous pension ponzi scheme should cause it to be forcibly ejected from the Euro, in a big bang that tosses out Greece, Spain and Italy.

Ah, France, another nation along with Greece, Spain and Italy that has a longer life expectancy than hard-working Germany. The Germans must be taught in school to feel really guilty over the crimes of their ancestors, that they put up with this.

Posted by DanHess | Report as abusive

The debate is not whether the price of overspending will have to be paid, but is who will be forced to pay.

– it could be the recipients of the overspending

– it could be the rich and powerful

– it could be the weak, uninvolved, and innocent

Any bets on where the burden will fall? Again.

Posted by txgadfly | Report as abusive

El Erian wrote:
“The unwind of unstable investor positions is still in its early stages. Having over-romanced the cyclical bounce, some investors are now scrambling to reposition their over-extended portfolios now that structural problems are undeniable. The resulting unwinding of overleveraged trades will inevitably disrupt a very wide range of other assets as the good gets contaminated by the bad.”

“We here at Pimco thought we were smart by buying German debt and avoiding Greece, which was obviously screwed. Now Germany is letting those dummies who invested in Greece escape and Germany will be left holding the bag, leaving Germany unable to cover its own hide. We are suddenly less fond of German debt.”

Posted by DanHess | Report as abusive

Where there’s no smoke break, there’s a fire break.

Track 2 from ‘Pricing In The Cost Of Chaos’ – latest record release by suave debonair blogger, international economist, TV personality and spiffy-dressing poly-talent Felix “DJ DrAchmaD” Salmon of that ilk, for it is he.

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Posted by HBC | Report as abusive

Now that Germany has agreed to quit whining and fall in line with the ECB’s plan, the debt can has been kicked WAY down the road and that’s a good thing for the euro.

Posted by STORYBURNcom2 | Report as abusive