Investors sent Europe’s politicians a painful message last week when Germany had a seriously disappointing government bond auction. It was unable to sell more than a third of the benchmark 10-year bonds it had sought to auction off on Nov. 23, and interest rates on 30-year German debt rose from 2.61 percent to 2.83 percent. The message? Germany is no longer a safe haven.
Since the global financial crisis of 2008, investors have focused on credit risk and rewarded Germany with low interest rates for its perceived frugality. But now markets will focus on currency risk. Inflation will accelerate and the euro may break up in a way that calls into question all euro-denominated obligations. This is the beginning of the end for the eurozone.
Here’s why. Until 2008, investors assumed that all eurozone sovereign bonds, as well as bank debt, were risk-free and would never default. This made for a wonderfully profitable trade: European banks could buy government debt, finance it at less expensive rates through funding provided by the European Central Bank, and pocket the spread.
Then credit conditions tightened around the world and some flaws became evident. Greece had too much government borrowing; Ireland had experienced a debt fueled real-estate bubble; and even German banks had become highly leveraged. Investors naturally decided some credit-risk premium was needed, so yields started to rise.
Greece, Ireland, Portugal, Spain and now Italy have large amounts of short term debt that they can’t roll over at low cost. Leading European banks are in the same situation. None of these countries or banks can long bear the burden of their current debt levels at reasonable risk premiums.
Many of Europe’s leading politicians, some International Monetary Fund officials, and the technocrats-of-last-resort ― Mario Monti in Italy and Lucas Papademos in Greece ― mistakenly believe that these risk premiums can be quickly reduced. They argue that if they cut budget deficits, carry out structural reforms and modestly recapitalize banks, their countries will soon grow and regain access to markets.
More realistically, none of these countries will be borrowing again soon in the capital markets. Ireland’s finance minister, Michael Noonan, is at odds with reality when he claims that Ireland should return to the markets in 2013. This is a country with 133 percent of gross national product in public debt and about 100 percent GNP in additional contingent liabilities to the banking system. (We use gross national product because gross domestic product is artificially raised by the offshore profits of non-Irish multinational corporations, most of which Ireland doesn’t tax.)
With such enormous debt burdens, even if the Irish or other troubled countries manage to convince the market that there is only a 5 percent to 10 percent annual risk of default, these countries will experience high real interest rates ― plus ensuing low investment and fragile banks ― for decades.
The French, along with U.S. and U.K. officials, are pleading with the European Central Bank to come to the rescue. Their hope is that the ECB can remove credit risk by promising to back all sovereign and bank credits in the eurozone. This is what politicians mean when they say “bring out the bazooka.”
When large amounts of any currency are printed in response to deep structural flaws, it’s hard to trust that money. A massive bond-purchase program by the ECB would reduce credit risk but increase the danger that the euro will decline in value against the dollar and other currencies. And if the ECB needs to continue buying more debt to finance deficits and prevent defaults ― because peripheral countries could stop making painful fiscal adjustments once the ECB starts buying bonds ― wages and prices would increase, as we saw in the U.S. in the 1970s. This is anathema to the Germans.
We would soon see German bonds sold off as investors protect themselves from long-term inflation, which erodes the value of such debt. People holding bonds with a high credit risk (such as Italy and Spain) would surely sell many of those to the ECB, or simply cash out when those bonds mature in case the central bank, at some point, stops buying.
An ECB “bazooka” wouldn’t restore competitiveness to Europe’s periphery, so even with this, Europe’s troubled nations would require many more years of tough austerity and budget reform to stabilize debt.
This would all just look like another unsustainable debt profile. Germany would be paying higher interest rates on its debt, while most banks and the periphery would be heavily financed by the ECB ― and both credit and currency risk premiums would remain. Markets would eventually turn against Europe with a vengeance, and with no more plausible solutions, the whole system would come tumbling down amid both inflation and debt restructuring.
Germany’s credit is impeccable, but the country is issuing debt in a currency that is flawed and could soon be worth much less than it is today. If Germany does block the “bazooka” and instead takes on more of the fiscal burden in Europe ― for example, through the obligations inherent in any kind of euro-bond issue ― this would reduce currency risk but undermine the country’s credit rating.
The path of the eurozone is becoming clear. As conditions in Europe worsen, there will be fewer euro-denominated assets that investors can safely buy. Bank runs and large-scale capital flight out of Europe are likely.
Devaluation can help growth but the associated inflation hurts many people and the debt restructurings, if not handled properly, could be immensely disruptive. Some nations will need to leave the eurozone. There is no painless solution.
Ultimately, an integrated currency area may remain in Europe, albeit with fewer countries and more fiscal centralization. The Germans will force the weaker countries out of the euro area or, more likely, Germany and some others will leave the euro to form their own currency. The eurozone could be expanded again later, but only after much deeper political, economic and fiscal integration.
Tragedy awaits. European politicians are likely to stall until markets force a chaotic end upon them. Let’s hope they are planning quietly to keep disorder from turning into chaos.
By Peter Boone and Simon Johnson
Peter Boone is a principal at Salute Capital Management and a visiting senior fellow at the London School of Economics. Simon Johnson is a professor at the MIT Sloan School of Management and a Bloomberg View columnist. The opinions expressed are their own. ― Ed.
