25 November 2011

José Manuel González-Páramo: Sovereign contagion in Europe

Mr José Manuel González-Páramo, Member of the Executive Board of the European Central Bank, focused his speech on the issue of contagion, and more specifically on the experiences with sovereign contagion during the European debt crisis and the related policy responses.

A first characteristic of contagion is that the spread of instability would usually not happen without an initial trigger event – which often appears to be a relatively contained event. A second characteristic is that the transmission of instability is in some way abnormal, for example, in terms of its speed, strength or scope. Though spillovers are to be expected in an interconnected financial system, contagion is distinct in that it often reflects a market failure and a dangerously amplified transmission of instability.

The underlying market failure consists of the fact that contagion often involves externalities. As a result, the private costs of the initial financial market failure, that is the costs to the actor triggering contagion, are lower than the social costs. In the specific case of the sovereign debt crisis in Europe, the trigger could, for example, be that a country in a precarious fiscal situation does not seriously implement the necessary fiscal consolidation measures. This could lead interest rates on this particular country’s government debt to rise and could in turn also constrain economic growth in that country. This is what I call the “private costs” of such behaviour.

The difference between private and social costs implies a market inefficiency calling for some form of intervention whose objective is to internalise these kinds of externalities. In other words, the countries that pursue activities which risk causing contagion need to be constrained in pursuing such activities or “pay a price” which is proportional to the expected costs to the other countries which are affected by the contagion. This provides them with incentives to reduce the activities that could trigger contagion.

Recent evidence on sovereign contagion in the euro area

There is a growing body of evidence which shows that contagion plays an important role in the current crisis gripping the euro area – across sovereigns, across banks, and between the two. The episode in question is the announcement by the Greek authorities on the first of November that a referendum on the rescue programme agreed at the EU summit the week before was being considered. The referendum was an event very specific to Greece. Indeed, the fact that this day was a public holiday in parts of Europe implies that the news flow on that day was more limited than usual.

In response to the announcement, yields on Greek government bonds and Greek sovereign CDS premia soared even further. The transmission of this shock to some other euro area sovereigns and euro area banks, in particular, appears to have been rapid, large and persistent. The CDS premia of France, Germany, Italy and Spain exhibited the largest one-day increase of the year. But whereas the CDS premia of France and Germany quickly receded to their previous levels, those of Italy and Spain further rose in subsequent days.

Sovereign contagion, the monetary transmission mechanism and the ECB’s Securities Markets Programme

The intensification over time of the sovereign debt has presented the ECB with the challenge of preserving the proper functioning of the monetary policy transmission mechanism. In normal times, the key interest rates decided by the central bank have an initial impact on short-term interest rates in the money market, and arbitrage relationships further propagate the policy impulse along the maturity spectrum and across different asset classes. Coupled with adjustments of money, credit and financing conditions, monetary policy can ultimately affect prices.

Faced with the risk of profound impairments of the transmission mechanism of monetary policy, the ECB has adopted several non-standard measures in order to maintain a stable relationship between its monetary policy stance and the conditions actually faced by households and firms. I will focus here on the Securities Markets Programme (SMP) adopted by the ECB in May 2010, given its direct relevance for addressing the malfunctioning of security markets.

The programme was designed in the form of interventions in the euro area’s securities markets. The liquidity provided by the central bank via SMP interventions is fully reabsorbed by other liquidity operations. The liquidity neutrality of the SMP interventions is one feature making them distinct from “quantitative easing”, which has the very purpose of increasing the liquidity provided by the central bank. In addition, quantitative easing programmes have a numerical target for the amount to be purchased. This is not the case for the SMP. Finally, quantitative easing programmes have a much larger size, given their intended aim of “flooding” the market with liquidity. A better-fitting analogy may therefore be drawn between the SMP and sterilised exchange rate interventions, which likewise do not necessarily have an announced target and aim to correct a misaligned asset price.

Conclusion

Looking ahead, the identification of the necessary reforms has to start from being clear about what the ultimate objective is: the need to establish institutional arrangements which provide credible incentives for sound fiscal and macro-economic policies in a monetary union.

Full speech

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