Posted by: Dirk | December 9, 2009

Contagion in times of crisis: the EU

No, this is not about influenza, but about contagion of financial crises. Greek government debt has recently been downgraded, and this might be bad news for Ireland and others, according to Gregory O’Connor:

The Irish problem with Greece’s growing troubles is that financial crises tend to be contagious. One of the “signals” that could instigate a sudden stop in Ireland is a sudden stop somewhere else, particularly somewhere with regional or trade connections.  This is why bad news for Greece is bad news for Ireland.  If Greece hits a sudden stop, Ireland will wobble, and will be the next in line for a sudden stop in Europe.

This is something that we used to see in developing and emerging economies during the Asian crisis of 97 when Russia, Argentina and Brazil wobbled in its aftermath. It is unfamiliar and slightly irritating to see it happen in the European Union.

Gregory O’Connor has only this advise to give:

In my opinion anyone who truly cares about the Irish banking system and its role in the economy should be encouraging the government to sell off the Irish domestic banks, shorn of the liability guarantee, and with the worst of their excesses spun off into NAMA.  If this were done, the risk of an Irish sudden stop would fall close to zero, and our sovereign borrowing rates would also fall sharply.  A sudden stop is an ugly thing and we should do everything we can to prevent it.  If the banks were safely inside large foreign holding companies then these insolvent Irish banks, and the risk they engender for the whole Irish economy, would cease to weigh down Irish economic recovery.

This is about priorities, and saving the government is higher on the list than saving individual investors. Government provides vital functions like enforcing the law, providing education and health care, and they are accountable through democratic rules. The case for rescue is strong, especially since it was not the government that caused the crisis.

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