Eurozone crises: the bigger picture

By Felix Salmon
March 3, 2010
Charles Forelle and Stephen Fidler have a really good front-page overview of the eurozone's fiscal situation in the WSJ today. There's not a lot of new news here, but as a lucid explanation of how we got to our present sorry state (and possible future even sorrier state), it's vastly superior to sensationalist conspiracy theories about euro-shorting hedge funds.

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Charles Forelle and Stephen Fidler have a really good front-page overview of the eurozone’s fiscal situation in the WSJ today. There’s not a lot of new news here, but as a lucid explanation of how we got to our present sorry state (and possible future even sorrier state), it’s vastly superior to sensationalist conspiracy theories about euro-shorting hedge funds.

So in the wake of the latest announcements from Greece promising fiscal rectitude in present and future — announcements which the market seems to like quite a lot — it’s worth bearing in mind two questions. The first, on which the market is currently fixated, is whether Greece can roll over its maturities in the next three months or so, tapping some combination of public bond markets, state-owned European banks, and EU loan guarantees. On that front, things are indeed looking pretty hopeful, partly thanks, as Sam Jones notes, to those very hedge funds which shorted Greece a few months ago, are making substantial profits by covering those shorts, and are now driving spreads tighter as opposed to wider.

The second question, which is much less tractable, is whether we can have any faith in eurozone government finances more generally, and this is where today’s WSJ article is so helpful, showing clearly that the truth has a tendency to come out very slowly and unpredictably, and that currency swaps through the like of Goldman Sachs are the least of the problem: governments hide much bigger debts by doing things like excluding defense expenditures or reclassifying subsidies as equity investments.

It’s worth remembering the famous convergence trade of the 1990s, whereby the wide spreads on what we now think of as PIGS debt all converged to something near zero as the euro approached: the idea was that simply adopting a single currency would mean an end to idiosyncratic credit risk between countries. In hindsight, that doesn’t make a lot of sense, since it was based on what Willem Buiter calls the “paper tiger” of the Maastricht treaty — the idea that somehow, after signing that piece of paper, sovereign governments would change the habits of decades or even centuries.

Of course it didn’t seem that way at the time. Because the PIGS were funding themselves in domestic currency, their credit risk pre-euro was very low, since they could and did always just print money to repay their debts. The result was high nominal interest rates to make up for high expected future inflation and/or currency depreciation. When those countries moved to the euro, the risks of inflation and currency depreciation were massively and credibly reduced — but no one seemed to worry overmuch about the fact that those risks didn’t simply disappear, they were just being transformed into medium-to-long-term credit risk.

Even at 400bp over German sovereign bonds, Greece’s nominal borrowing costs today are much lower than they were in the era of the drachma: the markets are requiring less compensation for Greek credit risk than they ever did for drachma depreciation risk. Maybe that’s because they have more faith in Greece’s fiscal rectitude today than they did in the early 1990s. And maybe that faith is well placed: the Greeks certainly seem pretty serious, these days, about cutting spending and increasing revenues. More serious than they ever were in the 90s.

But the fact is that the changes in nominal PIGS funding costs are not perfectly correlated with the fundamental faith that markets have in those countries’ fiscal sustainability, especially now that they’ve spent the past decade with no real control over monetary policy. So while the ouzo crisis might be waning, I’m sure that we’ll see more, similar, crises in future. Because southern Europeans can’t become Germans just by signing a treaty in Holland.

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