And so it is. Ten weeks ago, I issued a warning to Europe and in particular to the leaders of Germany and France:
The EU should not underestimate the likelihood of broader financial contagion within the Eurozone. Authorities would be remiss to dismiss Greece's troubles as purely idiosyncratic, as countries like Portugal, Italy, and Spain also boast weak fiscal positions, high unemployment, and large debt to GDP ratios. If Greece were to fail, these countries would be soon to follow. History tells us as much.
Ten weeks ago, it was clear that market confidence in the Eurozone was cresting. Today, Germany's window of opportunity to patch up Greece's finances has closed. Back in February, a hundred billion Euro debt guarantee could have scared the speculators and bought Europe enough time for structural adjustment. Now, the financial contagion has spread. Spanish and Italian bond yields are surging, signaling that investors are fearful that EU authorities will fail to stem the crisis.
Market volatility is back. Today, the Dow dropped 1,000 points before eventually rebounding to a modest overall drop of about 350.
Market participants are left to guess about the commitment of financial authorities to different institutions. Back in 2008, investors bet against the banks when they perceived ambivalence and confusion on behalf of the US Treasury and Federal Reserve. So too is the case today, where market participants divine the whims of agents such as Angela Merkel and Jean-Claude Trichet.
We have entered a new stage of the global financial crisis. To understand where the global economy is headed, we have history as a guide. Fine research by Carmen Reinhart and Kenneth Rogoff shows that historically, sovereign defaults follow in waves after financial crises. The reasons for this are manifold: economic growth slows, decreasing tax revenues and increasing fiscal deficits through countercyclical fiscal policy, while governments take on large levels of debt to stabilize their financial system.
Unfortunately for the Greeks, the future of the Eurozone is in Germany's hands. If Germany is willing to bear the costs of guaranteeing the liabilities of all of Southern Europe, then the Euro will survive drastically depreciated but intact. In all likelihood, latent and deeply nationalist persuasions of Germans will prevent the necessary countermeasures from being enacted. By constantly being a step behind the speculators, Germany will eventually have to allow some combination of debt restructuring, inflating away of liabilities, or outright default in debtor countries. No outcome is ideal, and all choices are bad.
Instead of narrating why bailouts of Eurozone members would be in the best interest of Germany, Angela Merkel has instead dithered, promising Germans political austerity measures in debtor countries in exchange for aid. This approach is misguided and assumes the luxury of time that simply does not exist. Markets are punishing Germany's indecision. The panic has taken on a life of its own and few solutions to the Eurozone's problems pass the political litmus test in Germany. Barring drastic reformulations of policy, the end of the Eurozone experiment might be upon us.
While the United States and Britain remain safely isolated from the sovereign debt worries of Europe, market sentiments can change quickly. Instead of basking in schadenfreude of the superiority of the dollar relative to the Euro, American policymakers should consider Europe's trials and tribulations a warning sign of things to come lest they change their course. Policymakers pay lip service to enacting some combination of higher taxes and less government spending to lower the deficit. Having good faith discussions about how to revamp fiscal policy to ensure solvency would be a good first step in preventing European financial collapse from spreading to US Treasury markets.
Ultimately, this economic crisis has proven the fallibility of our humanity. As the crisis endures, it is clear that markets are social arenas, where fears of financial contagion spread reflexively across seemingly disparate asset classes and across borders. With volatility spiking and a renewed sense of crisis upon us, economic interconnectedness and free capital flows unite the world in an interlocking web of vulnerability. Tough as it may be to accept, we are all Greeks now. Better to come to terms with this uncomfortable truth than to live in a state of denial. One day, Germany and the rest of Europe will realize this. The only question is how much pain they will have to suffer before then. Stay tuned.
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