Irish Crisis Demands New EU Response: El-Erian

Much of the economic focus this week has been on the group of 20 leading nations summit in South Korea, yet something equally significant has been happening in Europe. After a period of relative calm, measures of sovereign risk in Ireland, Greece and other peripheral European countries have shot back this week to alarming levels. They have done so in a manner that precludes easy solutions.

Pimco's Mohamed El-Erian
Pimco's Mohamed El-Erian

Consider three worrisome facts. First, default is now no longer just a Greek concern; measures of default risk for Ireland, Portugal and Spain reached record levels this week. Second, the drivers are now clearly internal, as opposed to some generalized deterioration in risk aversion. Third, this has happened despite continued buying of peripheral government bonds by the European Central Bank.

If these three trends persist – and they will do so, absent major policy change – European governments will soon face cascading challenges reminiscent of what emerging economies experienced during their financial crises of the early 1980s, mid and late 1990s and early 2000s.

Most fundamentally, advanced economies are not wired to operate at elevated levels of sovereign risk, be it Portugal’s 5 percentage points spread over German five-year bonds, Ireland’s 7 percentage points or Greece’s 11 percentage points. The longer these spreads persist, the greater the decline in investment activity and employment.

If things are left as they are the risk of further social unrest will rise, while tax revenues will collapse at a time when budgets are already under enormous strain. Meanwhile, institutions holding government bonds (particularly banks, pension funds and insurance companies) will have to confront the fact that they are sitting on large losses, and do so either on their own or through mounting downgrades by rating agencies.

The history of emerging economy crises also tells us that these worrisome dynamics are self-reinforcing, resulting in what economists call “path dependency”. Rather than snapping back to a better outcome, bad developments increase the probability that the next set will be even worse.

So far, Europe’s response has consisted of two elements: peripheral countries (and particularly Greece and Ireland) embarking on ambitious austerity programs; and, simultaneously, these countries receiving external funding through access to the ECB’s balance sheet and, in the case of Greece, loans from the European Union and the International Monetary Fund.

But the lesson of numerous crises in emerging economies show that this approach simply kicks the can down the road. It does not deal with the basic problems: the overhang of debt (an acute problem for Greece and Ireland in particular) and poor competitiveness.

It also involves significant regressive income redistributions – from private investors to taxpayers – and risks contaminating the balance sheets of the strong (ECB, EU and IMF) and undermining their credibility as effective crisis managers.

The policy responses of euro zone governments were supposed to buy a few years of calm, but ended up by delivering only a few months. A more effective and credible approach is now needed, before the deterioration in the peripheral economies contaminates other countries. The greater the delay, the larger the potential for Europe’s problems to disrupt what is already a fragile global rebalancing, and a stuttering American economic recovery.