Fear and loathing in the eurozone

by Martin Wolf

Financial Times
September 27, 2011

The annual meetings of the World Bank and International Monetary Fund over the weekend brought together frightened and angry people. The financial crisis that broke upon the world in August 2007 has entered a new and, in crucial respects, more dangerous phase. A positive feedback loop between banks and weak sovereigns is emerging, with a potentially calamitous effect on the eurozone and the global economy: the eurozone is no island. What makes this process particularly frightening is that weaker sovereigns are unable to cope on their own, while the eurozone has nobody in charge. The eurozone may lack the capacity to address the crisis.

The underlying danger is laid out in the latest global financial stability report from the IMF. This is surveillance at its best: clear, compelling, courageous. So what is the message? It is contained in two sentences: “Nearly half of the €6,500bn stock of government debt issued by euro area governments is showing signs of heightened credit risk”; and, “As a result, banks that have substantial amounts of more risky and volatile sovereign debt have faced considerable strains in markets.” (See charts.)

In their seminal book, This Time is Different, Kenneth Rogoff of Harvard and Carmen Reinhart, of the Peterson Institute for International Economics, explained that big financial crises have often led to sovereign debt crises. This is the stage the world has reached, no longer in small peripheral member countries of the eurozone, but in Spain and Italy. The emergence of doubt about the ability of sovereigns to manage their debt undermines the perceived soundness of the banks, both directly, because the latter hold much of the debt of the former, and indirectly, via the dwindling value of the sovereign insurance.

The IMF’s report lays out the processes: “Spillovers from high-spread euro area sovereigns have affected local banking systems but have also spread to institutions in other countries. In addition to these direct exposures, banks have taken on sovereign risk indirectly by lending to banks that hold risky sovereigns. Banks are also affected by sovereign risks on the liabilities side of their balance sheets as implicit government guarantees have been eroded, the value of government bonds used as collateral has fallen, margin calls have risen, and banks’ ratings downgrades have followed cuts to sovereign ratings.” As funding comes under pressure, credit shrinks and the private sector becomes more cautious, weakening economies and undermining both fiscal and financial solvency.

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