Global sell off and the EMU

Markets for risky assets — stocks, commodities — are down significantly around the world today. The selling is reportedly being caused by intensifying worries over government debt levels in Greece, Spain, Portugal, Italy, and Ireland (the so-called PIIGS), and the possibility of a sovereign debt crisis for one or more of them. The USD is up, continuing its months long rally.

The European Monetary Union is an interesting contrast to the U.S. It shares a common currency, the euro, which is analogous to the USD here. The governing agreements of the EMU require that each member state impose a certain level of fiscal discipline, i.e., government budget constraints. That’s the nominal policy, but imposing discipline on member countries has proven to be elusive. The important difference between the U.S. and the EMU is that our federal government sets both fiscal and (quasi-public) monetary policies at a national level, while in the EMU, monetary policy is set at the highest level, but fiscal policies are pursued by individual countries, and they can vary quite a bit, from German thrift to PIIGS’ profligacy (there also tend to be tighter constraints on state and local budget deficits in the U.S. than in some European countries). The result is that national governments in the EMU do not have the power to create the non-interest bearing debt (the euro) used to service their interest bearing debt. Technically, the U.S. doesn’t either, as the Fed is not a government agency, but it’s fair to say that Congress and the Administration wield far more power over the Federal Reserve than European governments do over the ECB. 

So when highly leveraged sovereigns in Europe run into trouble, like Portugal’s recent failed debt auction, there’s plenty of consternation and conflict among EMU members about the appropriate measures to take. That uncertainty may indeed be causing increased investor pessimism, and raising the probability that one or more of these countries defaults on its debt.

A CNBC commentator also pointed out that credit default swaps, the cause of AIG’s demise, could be playing a role. This market is still largely unregulated, unfortunately. If a CDS were nothing more than a betting contract between gamblers, they wouldn’t be a big deal. But the CDS market is huge. It has gone well beyond its primary purpose of hedging credit risk, instead allowing active and highly levered speculation on credit troubles, and the ‘notional’ value of contracts far exceeds the actual amount of debt outstanding. Many of the counter parties involved in the CDS market are intimately tied to the global payments system, so an implosion affects all of us. It’s for that reason that updated financial regulation is so critical, whether it’s to tax principal trading assets, limit the level of credit default insurance to the actual level of an issuer’s debt, limit or monitor systemic leverage, etc.

That segues into an important consideration regarding the potential economic impact of a sovereign debt crisis. Some analysts and commentators point out that the economies of the countries at risk are a small percentage of global or even European GDP. However, Lehman Brothers was also small relative to world or U.S. GDP. What’s important from a systemic standpoint is the number of financial commitments associated with the sovereign paper that is at risk of defaulting, i.e., the systemic fragility that could be exposed by such an outcome. The global financial system has deleveraged significantly since 2007, but from astronomical levels; a large loss on sovereign paper could still destroy a lot of capital in fairly short order. There’s also contagion risk — if more than one of these sovereigns were to default, the relative size of the problem would be larger.

Interestingly, we’re bullish on all but one of these countries in the longer term, so we’re looking for opportunity amid the crisis.  

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