The difference between Greece and Ireland

There are significant difference between Greece and Ireland sovereign crises. Greece was a crisis of public finance while Ireland is a crisis of private finance from banks.

The possible bail-out of private institutions actually has more market uncertainty and potential contagion because there is more choice on what could be the actions of governments. The bank run problem is also more likely for a financial firm than a country given the shorter-term financing of most banks. It is highly unlikely that governments will be left to default in the EU. Of course, it has happened in the merging markets as ell as developed countries.

On the other hand, it is easier to see governments walking away from financial firm bondholders. The bond holders are more likely to be placed in a first loss position as they rightly should. Given the uncertainty of whether action will be taken and then the reaction across other financial institutions. The Ireland case of the future is more risky. The country bail-out may have less contagion than the case of a country bank failure.

The elephant in the room - bond market markdowns

The elephant in the room is the determining who will or should take the credit losses from an adjustment in bond markets from a sovereign crises. The uniqueness of the Ireland crisis is that the credit problem was not from public finances but from private financing and credit expansion. Greek had terrible public finance. Ireland was running a balanced budget just a few years ago. The crux of the Ireland problem was the bail-out of the private banks which engaged in excessive credit expansion in a low interest rate environment caused by the ECB. There was no choice given the central bank controls a single rate for the entire EU.

What should have happened was a write-down in the debt of Irish banks. In fact, it is not clear that Ireland needs their own banks given interest rates are controlled outside of the country. So what would happen if just allowed the bank debt to be written down to zero or have to go through a bankruptcy proceedings. Each of the holders of the bank debt would take a loss. The issue would then be whether governments would want to bail-out the bond holders of their countries for holding debt in other institutions. If German or French banks were holding a high percentage of the Irish debt, they would take a loss and it would then be up to the German or French governments to decided whether there is a need to help their banks.

Swapping currency crises for credit crises

Martin Wolf for the FT focuses on the most important issue of the current Ireland crisis, the switching of currency crises for credit crises.

First, a single interest rate across countries with different relative cost structures will lead to boom and busts across the EU. There is no mechanism to control the localized credit excesses when there is a single monetary union. This problem becomes exacerbated when there is no way for prices to change in exchange rates.Without an adjustment of the exchange rate, there is no international price mechanism to adjust an economy when there is overheating through appreciation or depreciation during a recession. Without the price adjustment from exchange rates, there will be a downward spiral from debt deflation.

Economic adjustment in the EU can only be through credit markets which means that there will not be any exchange crises but more localized credit crises which will drive market extremes. That being said, we are having a currency crisis for the EU through a decline in the Euro. The size of the Euro adjustment will be associated with the relative size of the country crisis. The size of the Greece and Ireland debt problem relative to the overall size of the EU debt markets will provide some approximate value of the currency adjustment. Nevertheless, the majority of the credit crisis will be localized while the benefit of the euro decline will be generalized across the entire EU.

Hence, we have the issue of countries needing a credit bail-out that would to some degree be contained if there was a currency price adjustment. However, many currency crises also have credit crises at the same time. The two often cannot be separated. Now , the credit portion of a financial crisis will be more pronounced.

The new buzz word for 2011 - Deglobalization

Deglobalization may be the new buzz word for 2011. With currency wars, trade wars, capital controls and more geopolitical risk, there is a greater likelihood that the world will become less connected. While there has been much talk at G20 meetings, little has been accomplished. Special interests between developed and emerging markets have actually increased and cooperation has declined. The chance of global climate cooperation also has diminished. There is also less leadership for what has been called the Washington Consensus of free trade and open capital markets. This has been the glue for globalization.

Nevertheless, deglobalization will be a particular buzz word for the developed world. Less cooperation between developed and emerging economies may be offset by more bilateral arrangements between emerging markets, so perhaps the operative phrase will be the New Globalization that by-passes the EU and drives growth on a different level.