Friday, July 22, 2011

Latest European Bond Spreads

The wonderful graphic above comes from Calculated Risk.

The point I wanted to add is this: every bailout announcement has caused some kind of drop in the spreads, only to see them resume their growth afterwards.  Yesterday's plan has caused a smaller drop in the spreads than any previous bailout.  That suggests to me that spreads will resume growing again shortly, and that the speed of the crisis will begin to accelerate.  The plan announced yesterday lacks all credibility as a general response to the problems (see, for example, Megan McArdle's critique).

I am shifting my view on this situation.  It now seems to me that it's really about the political leadership of the Eurozone and the fact that Europe lacks the institutional capability to understand what it is up against, and respond decisively and effectively.  It's going to get much worse, until the Eurozone falls apart altogether, or Europeans finally get desperate enough to do something that's really going to work.

1 comment:

The Rational Pessimist said...

Unfortunately, I cannot see anything that is going to work that can keep the Eurozone together. Debt is not sustainable if you can't maintain a primary surplus (revenue higher than expenditure excluding interest payments) and the interest rate you pay on your debt is higher than your GDP growth rate. If you can't fulfill these conditions, your debt explodes.

Generally, states find it very difficult to maintain positive primary balances, particularly if they have to maintain large welfare transfers because of high unemployment and ageing populations. Indeed, those parties that try to balance the budget, generally get voted out of office.

There is a way out of this. The government maintains a deficit but you let inflation rip so nominal GDP (not real GDP) is higher than your interest rate. This is what the UK is allowing to happen at the minute. Its GDP growth rate is pretty lacklustre, but in nominal terms (adding in inflation) it is above 10 year bond yields. As a result, the value of debt shrinks in real terms.

Unfortunately for the basket case European economies of Greece, Portugal, Ireland, Spain and Italy, they can't do an end run around their debt and pump up the money supply to puff up nominal GDP because they don’t control their own money supplies. They are expected to either a) slash and burn on the revenue side to produce a positive primary balance over a multi-year time span or b) make amazing structural changes to their economies that suddenly produce an upward shift in their real GDP growth rates. These are tooth fairy outcomes.

In the real world, when your debt gets to a certain level against your GDP you can either default on it or inflate it away, and the European Union as it stands does not allow either outcome. As such, I just can't see how the EU will hold together. Or rather, it needs to return to being a political union rather than an economic union and let individual nation states produce their own messy solutions to their own fiscal impasses.