Sunday, November 27, 2011

Have All the Policies Designed to Insulate, Protect, Bail Out etc. Guaranteed Euro-contagion?

That's the question asked by Knowledge Problem's Lynne Kiesling:
“Death of a currency”
One of the great topics of discussion with my in-laws over the holidays was the impending demise of the euro, and whether there was any hope for, or reason to, maintain the euro given the sovereign fiscal challenges of the member countries. The disastrous German and Italian bond auctions, and Spain’s cancellation of its sovereign bond auction, seems to portend “eurogeddon”. One of the articles that helped me interpret these events was this column from Jeremy Warner in the Telegraph:
No, what this is about is the markets starting to bet on what was previously a minority view – a complete collapse, or break-up, of the euro. Up until the past few days, it has remained just about possible to go along with the idea that ultimately Germany would bow to pressure and do whatever might be required to save the single currency.
...But I have a simple-minded question to ask, perhaps one that I should have asked two years ago: why are so many people so worried about contagion from sovereign default in the eurozone? Should they be worried?

Typically, interconnected financial markets have negative feedback loops that lead to the dampening of propagation; price changes as investors move money around in response to changes in relative risk are an example of such a negative feedback. But with so many policies designed to insulate, protect, bail out parties, policies that introduce asymmetries by insuring against losses, have these negative feedback loops been distorted and replaced or outweighed by positive feedback loops that amplify effects? That’s how I’ve been thinking about the bailouts and subsidies and loan guarantees in both the EU and the US — policies that distort the negative feedback effects that can be equilibrating and introduce asymmetries that create destructive positive feedback effects, whereas before any disequilibrating events or shocks could have been smaller and dampened by the normal negative feedback effects in markets....MORE