The fear of unsustainable debt levels has spread from Greece, first to Spain and Portugal, then to Italy and now to France, Austria, even Finland. Investors who had been pleased to put their money into dodgy assets now fear everything but the very safest. In the old days, they fled to gold. Today, the equivalent of gold is German bonds. Private investors are selling everything else. There are few buyers beside governments and the European Central Bank. The possibility of defaults, of bank closures, and of global recession grows by the day. How did we get here?
Contagion is what the great Hyman Minsky and his populariser, Charles Kindleberger, call the final act in financial crises. According to Minsky there are five stages between bubble and bust. The first is displacement or innovation: something changes that makes a certain investment more profitable. In the 1990s, the promise of European unification and a single currency removed currency risk from the minds of European bond traders. One of the most profitable speculations towards the end of the last millennium was the convergence trade between German and southern European debt. Financiers were convinced that without the chance that the lira could depreciate against the Deutschmark, that Italian and German debt should have the same price. Now that proposition seems utterly daft, but back then, it made traders lots of money.
The second stage is expansion. Minsky reminds us that no boom can occur without fuel and that fuel is cash. Without easy money, bubbles don’t grow. The fuel was the German current account surplus. In the early years of this century, the German economy boomed, exporting far more to the peripheral European nations than it imported. This current account surplus needed to be spent and so it flooded out of German banks into southern Europe, funding condominiums in Spain and government pensions in Greece. For a while, everybody was happy.
The next stage, euphoria, peaked sometime around 2006. The spreads between German and Greek debt became infinitesimal. For a few extra basis points, optimistic traders were willing to ignore all sorts of dangers. Subprime mortgages, Indonesian corporate bonds, Greek government debt were priced as if they were almost risk free. The sad thing: traders made fat bonuses during those happy days despite the obvious idiocy of their speculations.
It turns ugly with the fourth stage, revulsion. The asset that had so recently tempted investors now fills them with fear. After Lehman Brothers, the sense of placid optimism evaporated and traders fled to safe havens. The lust for higher yield was replaced with the need to preserve capital, and investors burned by subprime debt wondered where else they had been blinded.
The answer: Greece, with high wages and low productivity, with spectacular government debt levels and little prospect for growth. Before 2008, eager bankers rolled over Greek debt when it became due, making paper profits for themselves and allowing continued Greek profligacy. By 2009 they were desperate to get their money out. To protect exposed banks the European Central Bank promised massive infusions of capital to buy maturing Greek debt, thereby keeping yields down to sustainable levels. The ECB had enough money to bail out Greece (or more accurately to bail out the banks that had lent to Greece) but nowhere near enough to bail out Spain or Italy.
And that is why we are in this mess today. Sometime over the past year, watching German politicians bloviate and Greek protestors riot, markets lost their faith in the ability of European elites to manage the crisis. Contagion has turned a mess that could have been manageable to one that is out of control. Just as euphoria blinds investors to risk, revulsion blinds them to opportunity. The assumption that Greek bonds are as solid as German bonds mutated into the fear that the Finnish or French economy is as fragile as the Greek. Neoclassical economics assumes investors are rational—but Minsky knew better.
