As we wait for ECB Mario Draghi to come good on his promise to do all in his power to save the euro, the case for governments intervening in financial markets is once again to the fore. Draghi’s verbal intervention last week basically opened up a number of fronts. First, he clearly identified the extreme government bond spreads within the euro zone, where Germany and almost half a dozen euro countries can borrow for next to nothing while Spain and Italy pay 4-7%, as making a mockery of a single monetary policy and that they screwed up the ECB’s monetary policy transmission mechanism. And second, to the extent that the euro risks collapse if these spreads persist or widen further, Draghi then stated it’s the ECB’s job to do all it can to close those spreads. No euro = no ECB. It’s existential, in other words. The ECB can hardly be pursuing “price stability” within the euro zone by allowing the single currency to blow up.
Whatever Draghi does about this, however, it’s clear the central bank has set itself up for a long battle to effectively target narrower peripheral euro bond spreads — even if it stops short of an absolute cap. Is that justified if market brokers do not close these gaps of their own accord? Or should governments and central banks just blithely accept market pricing as a given even if they doubt their accuracy? Many will argue that if countries are sticking to promised budgetary programmes, then there is reason to support that by capping borrowing rates. Budget cuts alone will not bring down debts if borrowing rates remain this high because both depress the other key variable of economic growth.
But, as Belgian economist Paul de Grauwe argued earlier this year, how can we be sure that the “market” is pricing government debt for Spain and Italy now at around 7% any more accurately than it was when it was happily lending to Greece, Ireland and Portugal for 10 years at ludicrous rates about 3% back in 2005 before the crisis? Most now accept that those sorts of lending rates were nonsensical. Are 7%+ yields just as random? Should governments and the public that accepts the pre-credit crisis lending as grossly excessive now be just as sceptical in a symmetrical world? And should the authorities be as justified in acting to limit those high rates now as much as they should clearly have done something to prevent the unjustifiably low rates that blew the credit bubble everywhere — not just in the euro zone? De Grauwe wrote:
Economists now agree that markets were wrong in placing the same risk premium on Greek bonds as on German bonds….the same markets are also wrong in overestimating the risk that the periphery countries will default. Policymakers looking to calm such skittish markets should take note.
You may well argue that if no one wants to lend, then no one wants to lend. But call up most fund managers or potential long-term creditors right now and they will tell you that they will buy Italy and Spain, when policy credibility is blessed by the “market” and rates are already falling. Hmmm. So, who’s setting these prices then? Oxford economist Simon Wren-Lewis in April made his entertaining thoughts on the danger of pandering to notional “vengeful god” of the financial market quite clear.