The picture I’m looking at shows five circles, with arrows connecting all five to each other, and other arrows shooting away from the circles into other directions. It is a complex illustration that would seem to depict some kind of a chain reaction, such as a nuclear blast.
What it actually shows is the debt of Portugal, Ireland, Greece, Italy and Spain, with the arrows highlighting how much of the debt is owned by investors in different countries. It is part of a presentation about sovereign credit risks by Citigroup.
“Not much scope for controlled explosions here,” says the heading. “Everything is interconnected.”
In spite of being only a small country in the 16-strong euro currency bloc, fears that Greece may default on its debts have not been contained. For many debt-watchers this comes as no surprise, precisely because of the close connections and links within the eurozone and the global investment universe.
Carmen Reinhart, professor of economics at the University of Maryland, who has studied debt crises going back 800 years, told me that people often remark to her how small a country Greece is, implying that its default should not have knock-on effects. “The origins of contagion have importantly a lot to do with financial interconnection, and we know that financial interconnections are strong in Europe and elsewhere,” she said in an interview. Another reason “small” crises can become bigger ones is the “wake-up call hypothesis”, in which “you look over your shoulder and say [about other countries], wait a minute, they look a lot like Greece”.
There are many common features of debt crises, including an unwillingness to address the problem, or acknowledge how serious it is. Indeed, even though world markets have jerked, leapt and tumbled as investors have reassessed risks in light of potential losses on Greek bonds, politicians have played down the messages these gyrations are sending.
“To some degree this is a battle between the politicians and the markets,” said Angela Merkel, the German chancellor. “But I am firmly resolved – and I think all of my colleagues are too – to win this battle.”
There is usually a political reason to play down the dangers or ill-effects of debts, as well as powerful practical ones – you don’t want to contribute to a loss of confidence. It is hard to embrace a reality that can only be addressed by cutting spending, firing people, slashing pensions, moving out of homes and other painful measures. Yet the potential for debt crises to spiral out of control is always there.
“When you’re highly leveraged, getting ugly doesn’t take a lot,” says Ms Reinhart, co-author with Kenneth Rogoff of This Time is Different, an analysis of debt crises. “One failed deal, one disaster in a placement of a bond, what would seem like a really short-run shortfall in rollover problems – anything can trigger that stampede scenario.”
This week’s market turbulence is a reminder how this can happen. There is often an unexpected factor that can fuel the rush for the exits – this week it was a likely breakdown in trading fuelled by computer programmes, the prevalence of which makes markets from stocks to bonds to currencies and commodities even more correlated.
“A series of self-reinforcing processes make markets, like piled snow, inherently unstable,” says Matt King, credit strategist at Citigroup. “What worries us most is the extent to which interlinkages between markets, and the all-important nature of confidence, still seem to be under-appreciated by investors and policymakers alike.”
The analysis that gets undertaken once a debt crisis hits could offer useful ideas of what should be done before debt is bought or sold. When countries – or companies – sell their bonds to investors, the presentations aimed at enticing buyers offer many jazzy charts and figures.
Grasping the bigger picture and links between risks is important. Some of the eye-popping charts in Ms Reinhart’s book would be one idea: they highlight just how frequent defaults and debt crises have been.
Ms Reinhart says the common traits crises share are two human features: “arrogance and ignorance”.
“The ignorance part is that oftentimes policymakers, investors, the everyday person, are completely unawares that we’ve been through this before; we’ve seen this movie before.
“The arrogance part is, well yes, maybe we are aware of it – it doesn’t really apply to us. We’re smarter than our predecessors; those old rules …things have changed, technology has changed.
“And so those things we should have heeded go unheeded, and that is a recurrent pattern.”
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