Downward Spiral (AKA DEFCON 4) BY MOHAMED EL-ERIAN

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Downward Spiral (AKA DEFCON 4) BY MOHAMED EL-ERIAN

Europe’s crisis is morphing again — for the third time in only 12 months — and the implications for the global economy are even more complex, unsettling, and troubling.

BY MOHAMED EL-ERIAN | DECEMBER 15, 2011

Downward Spiral (AKA DEFCON 4) BY MOHAMED EL-ERIAN

Europe entered the year with an acute emergency in the periphery of the eurozone, the European Union’s elite 17-member club that shares a common currency. Misdiagnoses and inadequate policy responses allowed the contamination to travel sequentially from the outer reaches of the zone (Greece, Ireland, and Portugal) toward its inner core.

In this first of three morphings in 2011, Italy and Spain were disrupted as interest rates soared, turning liquidity concerns into solvency ones. France was then impacted, with its AAA rating threatened by its exposure to the neighborhood’s problems. Then Germany, Europe’s strongest economy and the one that everyone looks to for a solution, had to contend with the embarrassing failure of a highly visible government debt auction.

A sovereign debt crisis is bad news for anyone with large holdings of government bonds. As European banks are the largest such holders, they quickly found themselves losing the confidence that is so central to the normal functioning of any financial system.

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Credit lines were cut, making too many banks heavily dependent on European Central Bank financing for raising the liquidity they need for daily operations. Equity prices collapsed as investors worried about bank profitability, thereby limiting the scope for injections of new capital. To make things worse, some depositors got nervous.

This series of events led to the second 2011 morphing of the European crisis. Having entered the year on the receiving end of the sovereign debt crisis, banks evolved into becoming a stand-alone source of disruptions — most acutely in the periphery, but also in some core countries. Suddenly, banks were in the grips of the threatening trio of liquidity strains, capital inadequacy, and concern about asset quality.

The alarm bells in European capitals rang even louder, prompting a subtle change in the policy emphasis. It was no longer just about saving the eurozone’s periphery. It became ultra-important, to use French President Nicolas Sarkozy’s words, to “refound” Europe.

As the crisis got bigger, Germany and France decided to dispense with the niceties of collective European deliberations and essentially specified the steps needed to strengthen the EU’s fiscal and institutional core. These measures found support, but not unanimous agreement.

Full article here-http://www.foreignpolicy.com/articles/2011/12/15/downward_spiral

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