Column : Positively contagious

Written by Hugo Dixon | Updated: Jan 19 2013, 07:02am hrs
Mario Draghi didnt quite coin a new phrase two weeks ago. But the European Central Bank president certainly popularised the expression positive contagion. After years in which the eurozone has been suffering from plain old contagionwhich doesnt even need the qualifier negativeDraghi now thinks a positive dynamic is in play.

The term contagion has tended to be used in financial markets to refer to the way that problems in one country (such as Greece) can so unnerve investors that they cause difficulties in other countries (for example, Portugal, Spain and Italy). Draghi, though, seems to be using the word more broadly to cover the whole panoply of vicious cycles that had been sucking the eurozone into a whirlpool.

The ECB president is right that the vicious cycle in financial markets has given way to a virtuous one. The best measure of this is how peripheral bond yields have dropped since he said last July that the ECB would do whatever it took to preserve the euroand believe me, it will be enough. Spanish 10-year yields have fallen from 7.4% to 4.9%, while Italian ones are down from 6.4% to 4.1%. The Stoxx 50 equity index, meanwhile, is up 12%.

But vicious cycles dont just apply to financial markets. They also affect the real economy and politicsand flip back then into the world of finance. Until Italy and Spain stop shrinking, the risk of tipping back into negative contagion remains.

Remember, too, how financial markets can be fickle. Only a year ago, confidence was buoyed by the ECBs decision to lend struggling banks 1 trillion euros of cheap three-year money. But then Greeces indecisive first election and Spains dithering over its banking reforms triggered the most dangerous episode yet in the euro crisis.

Still, before looking at the remaining risks, it is important to acknowledge the progress in both the underlying situation and confidence. The fundamental causes of the crisis were uncompetitive economies, excessive government borrowing and weak banks. All three problems have been partly remedied. For example, labour costs in Spain and Greece have been falling, improving their industries competitivenessso much so that Spain has had a current account surplus for the past three months. Meanwhile, fiscal deficits across the periphery of the eurozone have been cut although they are still too high. Finally, Irish, Greek and Spanish banks have been stuffed with capital.

Confidence, too, is returning. Its not just the sovereign debt yields that have fallen. Capital flight has reversed and banks are less dependent on the ECB for funding.

Positive contagion could work as follows. A growing conviction that the eurozone is addressing its problems and will not break up could strengthen confidence in financial markets. As borrowing costs in peripheral countries fall and their banks feel they are no longer on the precipice, companies and individuals will face less of a credit squeeze. Ultimately, businesses would invest and individuals spend. Measures taken to restore competitiveness would also encourage investment and increase exports.

All this would bring the recession to an end, which would cause a further boost to the confidence of investors, businesses and consumers. With interest rates falling and tax revenue rising, fiscal deficits would fallkicking off another virtuous circle, as governments would no longer be under pressure to tighten their belts with further rounds of austerity.

Unfortunately, it is still too soon to be sure of such a happy endinglargely because the measures taken to improve competitiveness and the impact of the better mood in financial markets on the real economy both operate with a lag. Meanwhile, the austerity measures are still crushing activity. The concern is that, in the interim, as unemployment continues to rise, the political situation in one or more countries could get nasty.

The political outlook is actually fairly benign because the two most vulnerable countriesGreece and Spainhave recently had elections and are not supposed to have new ones for several years. Meanwhile, this years German election could even be positive if it leads to a grand coalition with Angela Merkel as chancellor but including the social democrats, who may be more willing to lend a helping hand to their struggling southern partners. The same could be true if next months Italian election results in a stable coalition led by the centre-left Pier Luigi Bersani and involving Mario Montis centrist movement.

There are, admittedly, short-term risks. One is that Greeces fragile coalition does not survive an intensification in the economic gloom. Another is that Silvio Berlusconi somehow pulls off a coup in the Italian elections. But the biggest risk is that Spain, Italy and Greece, in particular, are still mired in recession this time next year. In that scenario, deficits would remain stubbornly high and debt/GDP ratios would still be rising, as would unemployment. Markets might then start worrying again about the sustainability of both public finances and governments reform policies, kicking off a new vicious cycle.

The eurozone is witnessing the early stages of positive contagion. But politicians should not be complacent. They must do everything in their power to maximise the chances of this virtuous cycle taking hold. This means keeping up their long-term structural reformsbecause the job of restoring competitiveness is far from donewhile trying to do whatever they can to mitigate the short-term austerity.

Hugo Dixon is Editor-at-Large, Reuters News