Does a European fire break exist?
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.