The Great Debate UK
The euro zone crisis has been a piece of luck for Britain. Imagine what would have happened without it.
In the immediate aftermath of Lehman, Britain’s position looked utterly hopeless. With a budget deficit of world-war proportions, and facing the cost of refinancing what had been two of the world’s biggest banks and were now two of the world’s biggest bankruptcies, the future for us at the end of 2008 looked dire.
Since then, our prospects have hardly been transformed, but we have at least been given a few years breathing space to get our affairs in order. For that blessing, we owe thanks to the Southern Europeans.
The initial reaction to the collapse of Lehman was a 20%+ fall in the value of the Pound, but that would only have been the start. As the full scale of Britain’s problems sank in, investors would have looked around for a safe bolt-hole, and they would not have had far to look. With a solid currency and sound finances, euro zone countries would have looked like attractively safe havens. Nobody would have been willing to hold UK gilts at a yield of only 3%, as they do today, when they could hold French, Italian or, better still, German debt denominated in euros, the world’s second reserve currency. In the flight to quality, investors would have flooded into the European bond market, deserting sterling and, probably, the dollar too. In order to finance our budget deficit, we would have needed to offer investors higher – probably far higher – yields.
Wednesday’s panic in the bond markets drove yields down to unprecedented lows in U.S., UK and Germany. The stampede into British and American debt is no surprise, since both countries represent a rock-solid guarantee of repayment in their own currency (though heaven knows how much lenders will be able to buy with the money in ten or twenty years’ time), but why the rush into Bunds?
One possible interpretation, which can never be discounted, is pure panic, based on nothing more rational than faith in Germany’s sleek cars, orderly cities and conservative bankers. But that is unlikely to be the whole story, if only because the trend has been apparent for too long to be put down to knee-jerk reaction.
The frosty reception given to US Treasury Secretary Timothy Geithner at the ECOFIN meeting in Poland last week tells you all you need to know about what is wrong with the EU. The hostility was directed not at the feebleness of the advice he had to give, but at the right of an American passport-holder to offer any advice at all to the policymaking elite of Europe, who are so obviously capable of handling the crisis themselves without any outside assistance.
For over a year now people have been calling for the collapse of the euro zone. Either one of the bailed out nations would leave, or the more fiscally sound northern European states would form their own version of a union. Regardless of what the outcome would be, the harsh reality was that the Eurozone’s massive floor - allowing countries like Greece to borrow for nearly a decade at German-style interest rates without some limit on spending or enforcement of fiscal rules – meant that it could not survive.
But after 18 months of stop gap solutions, emergency weekend summits and hastily constructed bailout plans it feels more and more like September may be the swan song for the currency bloc.
from Felix Salmon:
I was wondering if the state-level impact of a debt downgrade would be different, more severe.
from Felix Salmon:
Many thanks to Van Tsui and Scott Barber for putting this chart together for me. We're all used to seeing yield curves -- charts which show the yield, for any given credit, at various points along the maturity spectrum. This chart is different: it's a price curve. It just shows the price at which Greek bonds are trading, plotted according to their maturity.
And it's really odd.
To understand just how odd this chart is, it's important to realize that in the Greek bond exchange, there's only one menu of options for anybody holding a Greek bond. It doesn't matter if your bond is maturing in six months or if it's maturing in 26 years, the instruments you're given the choice of swapping into are all exactly the same.
from Felix Salmon:
Larry Summers reckons that "with last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase"; he's right about that. But his prescriptions for what must be done, laid out in the second half of his column, are a mess. For one thing, they're impossible to implement from a political perspective. For another, they contradict Summers's own diagnosis of what the problem is, as laid out in the first half of his column. And in any case they're a textbook case of too little, too late: even if implemented they wouldn't actually fix the problem.
Summers is quite right, in the first half of the column, to write this:
The approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative.
from Felix Salmon:
When a country is a serial defaulter, two things happen: it regularly writes down the value of its own debts, and it can't borrow money anywhere else. The result looks something like this:
The implication of this chart is that Ecuador is finally, perforce, living within its means -- something you have to do, if you have no ability to borrow.
Italy has hogged the headlines in recent weeks mostly for political reasons rather than financial ones. But in a few months we may be concentrating on its fiscal woes and unsustainable debt burden.
Last week credit rating agency Moody’s announced it was putting Italy on review for a possible downgrade to its Aa2 credit rating. These reviews typically last three months or so, and although a downgrade would still leave Italy at the higher end of investment grade, it is not good news to be sliding down the scale, especially when a sovereign debt crisis is raging further along the Mediterranean coast.
As the Greek tragedy goes into what looks like its final act, there is increasing talk of the country leaving the euro zone and refloating the drachma. Perhaps the Athens street mobs favour this “solution”, but what would it involve, and would it work?
It is a bizarre situation, without precedent as far as I am aware (though I am no economic historian). Usually, new currencies are introduced to replace old ones which have become discredited (typically after hyperinflation), whereas here we are talking about the absolute opposite: abandoning the euro because it is too strong, in favour of a new drachma, which will be a weak currency by design – rather like launching a ship, in the hope it will sink!