The takeaway: Germany is pot committed
The short-term market reaction to the Spanish bank deal should not blind us to the important longer-term implications: Germany is now pot committed.
Most of you know the poker term, I suspect. Pot committed is when you have bet such a large percentage of your chips that you cannot fold your hand. You are not all-in yet, but you eventually will be unless the others fold. (“Crossing the Rubicon” has roughly the same meaning, but seemed a little too evocative in the present context).
The Spailout, as it is being called, is the biggest one-shot resource commitment the EZ has made in this crisis. In fact, the commitment seems somewhat open-ended. And it is the first one explicitly made (SMP purchases are really indirect) to a large EZ member state. Moreover, reading between the lines of the official statements from inside and outside the EZ indicates a fairly high degree of commitment to going further and forging a banking union. There are increased murmurings of fiscal union as well. Greece may be already outside the circle of trust, but all this suggests that the EZ—and Germany—very much wants the rest of the EZ to be indivisible.
I have serious doubts about the feasibility of these ambitions, but this is not germane to the point here. What is germane is this: If Germany is indeed pot committed, and you believe as I do that the other players are not going to fold (i.e. the crisis will continue), then we now know on whom the peripheral countries will default.
It will be the official sector and local banks, where the risk has been increasingly concentrated with each round of official intervention. The supranational institutions take down a lot of the bad assets, plus Spanish banks buy the Spanish debt, Greek banks the Greek debt, Italian banks the Italian debt, etc. This is, has been and, we now know, will be the dynamic.
Whether the bulk of default falls on the official sector and local banks, or the default falls on markets makes a big difference for contagion beyond the defaulting countries. If market participants are levered long troubled assets, or own troubled assets and are elsewhere leveraged—as was the case for markets pre-Lehman—contagion will be severe and collateral damage great. If, on the other hand, the official sector and the local banks (de facto official sector) own the bulk of the risk and market participants are not, in general, highly leveraged, the consequences—while still brutal for the defaulting countries—will not propagate through the rest of the financial system with anywhere near the same violence.
I am not arguing there will be decoupling. But for a number of months now I have been trying to gauge on whom EZ defaults will fall, the private sector or the official sector, because, ceteris paribus, the contagion implications are vastly different. And now I have my answer: Germany is pot committed, and the other players are not about to fold. This might not be fair or even efficient, but it matters a lot for eventual burden sharing, and on this count we just found out that markets are going to come out well ahead.