Last week was dominated by two R-words: “referendum” and “recession”. The announcement that a referendum would be held in Greece on a yet to be decided question came as a bolt from the blue. Several weeks ago the Bloomberg website had posted a similar report from Greece, but this was denied by Athens the following day. This time it was serious. At least for a few days. The strength of the market response was linked to the introduction of a new kind of uncertainty: would the referendum be about membership of the eurozone, a question which was thought to be taboo until recently? One can imagine the endless media debates between supporters and opponents. It would have been reminiscent of the debates preceding the referendums on the Maastricht Treaty in the 1990s. But these debates were small beer compared to the issue at hand. A second kind of uncertainty was of course what would happen if the Greeks voted “no” on whether to stay in the eurozone. And then there was a third kind of uncertainty, namely whether the Greek precedent would spark calls for referendums in other countries.
So relief all round when the referendum idea was scrapped on Thursday. The key word in this whole saga is “uncertainty”. In this context I recently read an interesting IMF paper entitled “The uncertainty channel of contagion”. The authors show that uncertainty can lead to contagion, regardless of the traditional channels of contagion. These traditional channels include commercial relations (the trade partners of an ailing country become “infected”), or comparable characteristics (countries which are also ailing come under speculative pressure). “Uncertainty” is a completely new channel: surprises on how the situation develops in a particular country raise doubts about the correctness of the analysis for other countries, and these doubts are sufficient to cause contagion in those countries. Or to put it differently: investors do not want to get their fingers burned again and prefer to be safe than sorry, with the upshot lower share and bond prices. The underlying cause: increased uncertainty.
The second R-word is “recession”. There is no uncertainty on this count, at least not according to the ECB president, Mario Draghi, who in a press conference last Thursday spoke of a “mild” recession in the eurozone. Investors should welcome such clarity, if only because it leaves little doubt about the direction of the policy rate: further downwards.
William De Vijlder
8 November 2011
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