Financial contagion

Thirty-one years ago this week the great Bob Marley passed away and ascended to the great Rasta heaven in the sky. For most of us, Marley was reggae and reggae was Marley. I remember the day he played in Dalymount in the summer of 1980. What I actually remember most (I was too young to go to the gig) was the lingering smell of ganga on the 7A bus that afternoon, as half of the ‘Noggin obviously skinned up on their way into town to pay homage the great man.

And paying homage is the right word, because it was the last outdoor concert Marley ever played. He died less than a year later. The cancer which had started in his toe, spread rapidly. Urban legend has it that Marley contracted an infection after injuring his toe playing soccer (by the way if you ever want to see an natural player with the ball at his feet, google “Bob Marley playing football”). The soccer story isn’t true.

Marley, who’s Dad was a white Englishman, suffered from a malignant melanoma found under the nail of his toe. It is speculated that because he was half-white living in the Caribbean, he was more susceptible to this type of skin cancer.

What is true was that his doctors suggested that he get his toe amputated. Marley refused on the grounds at Jah Rastafari stipulated that humans shouldn’t permit their own flesh to be cut. Marley’s life would have been saved had he had the amputation. Tragically the cancer spread and his health deteriorated rapidly leading to his tragic demise.

Watching the latest twists and turns on Europe’s road to financial calamity as each financial crisis mutates into a banking crisis and then into a bond market crisis and then into yet another capital flight crisis and ultimately, now to a political crisis, I am reminded of Bob Marley.

Financial market contagion, like contagious diseases, spread and mutate if you don’t deal with them early and decisively. They get worse, not better. This is the lesson of Europe in the past four years, and of the Asian crisis in 1997 and the Latin American debt crises in previous decades. In the case of Europe, a financial crisis first became economic and then jumped over to become a full-blown political crisis. The political scalp of Sarkozy is only the latest victim.

The European elite’s response has been to kick the can down the road as they say, in order to buy time and hopefully time will heal all. But time doesn’t heal at all. In fact it gives the contagion the time to mutate and become more virulent.

The more the EU pretends that peripheral countries are solvent the less people believe it. The infection rather than getting better gets more aggressive and it changes its nature, like mutating cells. It affects banks and companies, it then affects house prices and then it mutates back again to hamper economic growth. The faltering growth rates, drive up unemployment. Once unemployment starts to rise, politics falters and incumbents get kicked out.

Not only that, but big dreams of political integration and the like, seem really unnecessary and indicative of a deep disconnect between politics and the people. In these instances, the people just get fed up and tell their politicians to snap out of it via the ballot box.

Ultimately, Europe has four problems. The first is not enough growth; the second is too much debt; the third is no political leadership and the fourth is the political illegitimacy of the technocrats that have been installed to run the economies on the periphery.

Growth won’t return until the debt overhang is eliminated but the debt overhang will not be eliminated without growth. Unless of course, there is a managed default. The only way out of this growth and debt dilemma is some sort of default, somewhere fast.

In order to facilitate this the ECB will have to be involved and this means persuading Germans that the Euro will only be fixed and the continental economy put back together if the core issues of over-borrowing in the periphery and its handmaiden over-lending by the core is fixed. This must come through a mutual deal between the debtor and creditor countries. This is called co-responsibility.

The “fiscal compact” will not sort this. In fact, it will make the situation worse in the short-term because it will reduce growth rates in those very countries, which have too much debt. Eventually these populations, which are already showing their dissatisfaction at the polls, get fed up.

There’s a common misperception that countries default on their debt because they can’t pay back the money they’ve borrowed. This is rarely the case. For the most part, countries default because their citizens get sick of the hardships they have to endure because of onerous debt repayments. And it becomes politically impossible for governments to continue honoring their commitments to creditors. Default is a strategic decision.

One of the best books published in recent years of these financial episodes was a study of debts and defaults by Ken Rogoff and Carmen Reinhart called This Time It’s Different. These scholars point out that more than half the defaults by middle-income countries occur at levels of external debt relative to GDP below 60% Europe’s debt levels in the periphery are close to twice this.

History shows that “willingness to pay, rather than ability to pay,” as the authors put it, “is typically the main determinant of country default.”

As the crisis mutates and mutates all around Europe, the point at which the people will get fed up will come sooner rather than later. Contagion can only be stopped by decisive action. Buying time just makes the ultimate crisis much more disruptive.

When I hear politicians contenting the opposite, whether its about the fiscal compact or the growth by austerity argument, it strikes that they are smoking something stronger that the heads on the 7A in the summer of 1980.

Urgent Appeal