Richard Baldwin on ‘Phrase 2 of the Eurozone (EZ) crisis’

An excellent article by Richard Baldwin at from 5 September provides a great overview of the linkage between the various crises gripping the eurozone (EZ) and how we may be entering (or are already in) the next phase of these series of crises. Baldwin illustrates their interconnectivity with a simple diagram which PIIGSty has tidied up for clarity.

The connectivity is as follows:

(A) Lehman Vortex

  • Banks rely on investor and consumer confidence. Without confidence, investors and consumers withdraw their funds and the bank becomes insolvent (unable to fund its day to day operations).
  • When Lehman collapsed on September 15, 2008 – a plague spread rapidly through Wall Street as fast moving investor capital began to flood from (up to then) other steady investment banks
  • This is a self fulfilling prophecy – if investors/consumers believe their bank is about to go bust and their cash to disappear, they will rush to (or ‘run on’) the bank and withdraw. Similarly, interbank lending (banks lending to each other) is likely to completely shut down. Banks can’t access funding – so who do they borrow from?
  • This means that just the fear of solvency freezes long term funding making banks insolvent.

(B) Sovereign & Implicit TBTF ‘Irish’ Vortex

  • Large bank failures and their threatened insolvency, due to their integrated nature of national economies (the body) and banking credit (the blood that circulates) – mean that insolvent banks can cause sovereign insolvency. This requires, as in Irish case, direct funding from the exchequer funded by sovereign debt.
  • The opposite is also true of the PIIGS-Northern European bank relationship – where banks hold PIIGS national debt meaning sovereign insolvency (in the periphery) can cause bank solvency (which causes a cyclical effect and the process repeats). This why ‘burning the bondholders’ in Portugal/ Ireland/Greece really means scorching Northern European commercial banks in Germany, France, Belgium, the Netherlands and others – a potential destabilising factor for otherwise stable economies.

(C) Austerity-Trap Vortex

  • If a nation tries ‘too little too late’ Greek style reactionary austerity policies, it can get caught in an ‘auserity trap’ where stringent cuts lower income levels, depressing tax revenue, raising spending on welfare and ultimately making increased borrowing necessaryworsening deficit/debt levels

(D) Debt Service Vortex

  • Nations spending becomes orientated not toward their taxpayers but toward paying debt levels of a past generation, contributing a significant proportion to exchequer spending.

To end the cycle, the options are pretty sparse, and both are debt laden, politically painful options for the richer EZ members (and aren’t particularly short term solutions either)

  1. Adopt credit debt smashing domestic institutions  i.e. adopt a stringent line on debt
  2. Gift national fiscal policy to a higher coordinated authority via fiscal union


The bottom line? So long as economies are in recession, these 4 branches/vortexes of the current EZ crisis will continue. Yet we still live in uncertain times with daily warnings of a return to negative growth and the spectre of a double dip recession in many economies. Recessionary fears stoke these 4 branches, injecting uncertainty back into the system in a painful cyclical repetitive process that European leaders seem content to oversee as hand wringing spectators. That is what caused Italy and Spain, as well as French banks and others to head south recently before stabilising again.

When European leaders meet, the panic subsides. Echoing Mr. Baldwin, PIIGSty firmly hopes “[that European leaders] actually get up and put the crisis to bed, rather than hitting the snooze button and heading back to bed themselves.’ Who knows! Maybe the markets are pushing the leaders into action. Lets hope it doesn’t require a real scare.



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