Last week saw an acceleration of fears about a sovereign debt crisis particularly in Europe. For a while now there has been debate and concern around Greece. This has now spread to Portugal Ireland and Spain. So there is a danger of Europe having to deal with several crises at once. Interestingly if anything Thursday and Friday saw more distress in equity than bond markets particularly in Portugal and Spain. Dow Jones has a 600 stock index for Europe and up to the close on Friday it had fallen 9.7% since its recent peak on the 19th January 2010. This morning as I type it is rallying and European equity holders must be very grateful for the resilience and rebound shown by the American stock market late into the evening European time on Friday.
As a measure of the situation I feel that there are three things to consider.
1. Ten-year government bond yields when compared with the German bund. If you like German bond yields are used as a yardstick to compare different countries.
2. Actual bond yields at the ten-year maturity. This gives us an idea of what governments will have to pay. I have read some ill-considered writing on this so let me explain how it comes into play. What it is telling us is the cost of issuing new debt as a yield rise in itself does not cost a country anything on its existing debt (it will cost the holders of the debt many of whom will be domestic investors but I treat this separately). New debt is issued by governments for two reasons. One is to replace old debt as it matures and the other is to finance a fiscal budget deficit.If you think of the situation logically given a choice none of the countries listed above will find having to replace matured debt much fun as it will be more expensive to issue the new debt as a higher yield will have to be offered. Also there is going to be a lot of new debt issued this year as fiscal deficits are high particularly in the so-called Pigs (Portugal, Ireland, Greece and Spain) and so this will be expensive.
3. Another measure is changes in the yields above. This is a measuring stick of the strength of the crisis.
So having set the criteria here are the results.
1. Comparison yields: Greece +3.52%, Portugal +1.61%, Ireland+1.58% and Spain +0.98%.
2. Actual yields: Greece 6.59%,Ireland 4.74% Portugal 4.71%,Spain 4.12%.
3. Now let us look at the situation on the 8th November last year (3 months ago). Ireland +1.42%, Greece +1.38%, Spain+0.54%, Portugal +0.51%.
This crisis actually makes the underlying problem worse. The problem is fiscal deficits which are too high and the market response of requiring higher yields makes the fiscal problem worse as higher debt interest gets added to the deficit. Remember this is only when new debt has to be issued but has to be paid until the bond matures. The world has moved from the virtuous circles of the early part of this century to vicious ones.
Existing investors will be sitting on losses. Here is an issue rarely debated but there must have been large losses in these markets. If we take the most severe example of Greece the rise in yields of over 2% at the ten-year maturity will have punished existing investors who have held on. Also please note quite a high percentage of Greece’s debt is held abroad, much of it believed to be by German institutions.
Ireland has been rewarded for taking positive action. Actually this was true before the crisis as Ireland paid down much of her national debt from the mid-1990s until the crisis hit and because Ireland had an austerity budget last year. So there is a reward for discipline.
Spain and Portugal are on a slippery slope. Portugal has seen her yields rise by 1% over this period with a lot of this coming recently. Her finances and her economy are in trouble and so it would seem is her government. Ireland has shown that this can be stopped and held but both Spain and Portugal need decisive action and soon.
What they do not need
Greece Spain and Portugal are all suffering from outbreaks of industrial action. In Greece tax collectors went on strike on Thursday and this plainly does not help the governments stated plan of cracking down on tax avoidance. A wider public-sector strike is due this Wednesday. Apparently even the unionised prostitutes have gone on strike. Fears of wide scale industrial action have contributed to the Portuguese government problems and its recent loss of a finance vote. There are threats of industrial action in Spain too.
These countries need industrial action like Arsene Wenger needs to see Didier Drogba again.
Europe’s real problem
A big part of this current problem is that those who have pushed Europe’s federal project have overreached themselves. There always was the flaw that currency union requires fiscal and political union too. Whilst they have admittedly pushed hard for political union (ignoring democracy in the process) if you look at the Euro zone the fiscal position has diverged and got worse. Also they have been willing to turn a blind eye to countries such as Greece whose application for entry for the Euro was fraudulent.
In addition there was no crisis section in the Euro constitution. Part of the reason for this was it was hard to have one when you have the flaws listed above as a solution involves spending money and Europe does not have full control over its budget. Also I suspect some vanity was involved and use of the phrase “this time it will be different” which in my experience invariably ends in tears.
When the banking crisis hit in 2008 Europe impersonated a rabbit caught in a cars headlights for a while. Because it has no system for crisis management it always hopes a crisis will go away (what I call the ostrich response). At the moment it is doing the same probably because of two factors. One is they do not know what to do and the other is the scale of the potential crisis.
I have thought since this crisis began that Europe would probably bail out Greece with the biggest danger to this being other countries in the Euro zone also requiring help. Sadly for Greece this is looking ever more likely.
My suggestion to Europe’s politician’s is that they need to decide what they need to do and quickly. There is still time but they are at risk of being at the mercy of events.
Eastern Europe and the International Monetary Fund
A problem with the International Monetary Fund riding to the rescue can be seen in Eastern Europe. There are problems in the Baltic states, Hungary, and Romania so it is likely to be called upon in quite a few areas and so I tend to feel that the Euro zone will need to help its own. Whether the German taxpayer sees it like that is another matter.
An illusion of our times
I have lost count of the number of times I have heard the phrase export led growth this year. President Obama was the latest to say this last week. The main net exporters around the world seem still to be exporting but now many deficit countries see this as a way out. Individually one can but without a lot of world growth collectively we cannot (unless there actually is a man in the moon and economies throughout the Solar System ).
The last time this phrase was used so frequently was the 1930s and we all know what happened then…..