Friday, July 22, 2011
Here on News N Economics, I’ve generally not commented on the politics of the sovereign debt crisis in Europe. Regular readers are well aware of my skeptical outlook on the growth prospects for countries forced into fiscal austerity amid piles of private-sector leverage, a slowing global recovery, and a central bank with a tightening bias. However, Tyler Cowen points us to various reactions (H/T RJS) – I’ll break my silence here and likewise comment on the latest Eurozone policy response.
The latest response to the Euro area banking, economic, and now fiscal crisis was heavy on promises and light on details and substance. Specifically, it outlines 16 different measures on 4 pages of text. The optimists – you know, the ‘glass half full types’ – see the ‘increased flexibility’ of the EFSF fund, or point 8. of the announcement, as a boon to the single-currency union. I see it as one step closer to the point where Eurozone policy makers will ultimately decide whether they're willing to institute a policy to keep the 17-country 'zone' together or let it fail.
Point 8. gives the European Financial Stability Fund (EFSF) the ability to do the following with ‘appropriate conditionality’: act on the basis of a precautionary programme; finance recapitalization of the banks for countries not in the EFSF programme; and purchase bonds on the secondary market (what the ECB was doing under its Security Markets Programme).
This is all fine and dandy; but these measures will do nothing to stem the contagion. Basically, the size of the EFSF is effectively too small to really make a difference, 323 billion euros remaining (note too that the 'full' EFSF lending capacity, 440 billion euros, has only been agreed upon, not yet ratified by all the governments at this time). If Ireland or Portugal were to need new assistance - this is not unlikely, in my view, given recent data coming out of Europe (H/T Credit Writedowns) - the remaining funds would quickly dissipate. Forget about Italy - it's too big. According to Bloomberg (not shown) 418 billion euros worth of Italian sovereign debt will mature through 2012.
The size needs to be bigger, yes, but this clinging to conditionality of fiscal austerity is the true weak link. “Strict”, “appropriate”, or “adequate” conditionality is a prerequisite for accessing the EFSF in any form. Conditionality for an autonomous sovereign government without autonomous monetary policy means fiscal austerity. And fiscal austerity for Europe means growth risk. And growth risk is now morphing into sovereign risk via weak domestic demand and rising fiscal deficits. There’s practically no way out except under fiscal union - or some version of it - and this must entail (literally) unconditional transfers.
It’s not a currency crisis, it’s a bond market crisis.
One can point to market reaction as testament that yesterday’s announcement was a successful response. Since July 18th (the day that bond investors started the long-standing tradition of “buying the rumor”) 10-yr yields across the Euro area fell precipitously: 171 bps in Portugal, 54 bps in Italy, 55 bps in Spain, 219 bps in Ireland, and a quick 353 bps in Greece. The biggest moves were in Ireland, Portugal, and Greece, where the curves shifted to reflect the lower borrowing costs and longer loan maturities. Furthermore, the euro gained 1.8% against the US dollar (+2.24% through yesterday).
It’s all about levels. Despite the quick drop in yields, today’s spread of 10-yr Periphery bonds over a like German bund reflects a substantial mismatch of risk: 815 bps for Portugal (that’s Portugal must pay 8.15% effective interest on a 10-yr bond above Germany’s 2.8% 10-yr borrowing cost), 262 bps for Italy, 296 bps in Spain, 907 bps in Ireland, and a completely unmanageable 1,187 bps for Greece. Note, Greece, Ireland, and Portugal do not pay these rates, since they are blanketed for now under an EFSF program or bilateral loans. Ironically, despite the clear crisis in bond markets, the euro is up 12.6% against the dollar in the last year.
A friend pointed me to a CNBC interview with Warren Buffett from July 7: This is what he said when asked about the Euro area: “When you have 17 countries that all have the same currency, and the yields on their bonds are dramatically different, the situation is not solved.”
He’s right. If the US States are any comparison, let’s see what a ‘divergence’ in pricing and risk should mean for a single-currency union. A AAA 10-yr Maryland municipal bond trades at 2.68%, while the worst (in pricing) of the States, Illinois, which is rated at A1/A+, trades at 3.98%. That’s a 130 bps risk premium for a 4 notch rating differential. Forget the ‘worst’ in Europe, Greece, because it’s about to go into default. Or even the next or next or next worst in European bond pricing (in order, these would be Ireland, Portugal, Spain, and Italy). But Belgium, an Aa1/AA+ country is trading at 145 bps over the AAA Germany and just one notch lower in rating, Aa2/AA+. Something’s wrong here; bond markets are still in crisis mode.
This policy response is not a boon to the Eurozone, it’s just a step closer to the crisis point - the point where policy will determine whether the euro dies or survives.