The fear of contagion in Europe

by Paolo Manasse and Giulio Trigilia

Vox
July 6, 2011

Most analysts agree that Greece is insolvent. This column argues that the issue is whether Greece’s troubles are contagious.

What to do about Greece? So far, much of the debate has split into two camps:

• bail-in-ers, the advocates of coercive (but soft) restructuring of Greek debt, and
• bail-out-ers, those who favour the procrastination of EU-IMF lending plus “voluntary” rollover.

Little of this debate hinges on whether Greece is solvent or not. Everyone agrees that, barring a miraculous rebound in growth, Greece is broke.

It’s the contagion we are struggling against

The argument among in-ers and out-ers hinges on the fear of contagion. Should investors overreact and flee from Spanish and Italian debt, things could get very ugly, very fast. We are talking about widespread European sovereign debt and banking crises. This would force a choice between

• A full-blown monetisation;
• The break-up of the Eurozone.

The bail-out-ers’ argument is well exemplified by Lorenzo Bini Smaghi (2011) of the ECB Board:

...The third feature that generally sets sovereign and corporate debt workouts apart is the externalities they may generate … Imposing haircuts on private investors can seriously disrupt the financial and real economy of both the debtor and creditor countries.. This is particularly the case in a region like the Eurozone…,where [a default could] destabilise the Eurozone financial markets by creating incentives for short-term speculative behaviour.

More