James Saft is a Reuters columnist. The opinions expressed are his own
HUNTSVILLE, Ala. – Europe is demonstrating that a sovereign nation without a true central bank is just an uninsured bank, liable to be tipped over by the markets.
While the ECB is a central bank in almost all respects, what it isn’t is a lender of last resort for individual euro zone nations, a role that is expressly ruled out by the European Treaty.
A lender of last resort is what stops a bank run on a solvent institution from bringing it down due to a lack of liquidity. In the case of a nation, a lender of last resort, usually the central bank, can simply print money to satisfy debts in its own currency. And though we’ve all become terribly cynical about the concept of liquidity crises in the past couple of years, not least because so many people in authority have used it as a place to hide when the real issue was solvency (Greece, Lehman Brothers), the fact is that markets take on their own momentum.
Just as no-one viewed euro zone debt as anything other than a safe haven for the currency area’s first decade, now investors are busy driving up the price of even German default insurance.
This is the terrible logic of markets when they view sovereign borrowers as credit risks; it is almost inevitable that they push, and in pushing weaken the un-backstopped borrower and ultimately bring it down. This is a process which needs a circuit breaker, and Europe has no adequate circuit breaker, unlike Britain or the U.S.
“Rather than viewing government bonds as risk-free, safe-haven assets, financial markets now view and trade euro area sovereigns mainly as credit risks. This has very profound consequences for the stability of financial markets,” economist Elga Bartsch of Morgan Stanley wrote in a note to clients.
“For it seems to me that some markets have lost their ability to find a new, stable equilibrium. This is because, instead of moving in sync with the business cycle, government bond yields now move against the cycle, ie, rising in a downturn. This seriously undermines the ability of the government sector to stabilise the economy and the financial sector.”
Bartsch looked at all sovereign borrowers since the mid-1990′s whose spreads above Treasuries rose to at least 10 percentage points, an indicator of distress. In only 20 percent of the cases did a debt restructuring, or default, ensure. Some were rescued by the IMF but many righted themselves.
Thus Europe is at the mercy of markets, left without a central bank or outside force which can break the cycle and impose order. The ECB has purchased government bonds as a back door means of providing support, but this is awkward, will ultimately test the limits of the bank’s capital and, as being against the spirit of EU law, is deeply divisive. The EFSF fund is not well suited for playing this role either.
FOOL ME ONCE
You could object that, of course, all sovereign borrowers are ultimately credit risks. Even if one is repaid in the sovereign’s currency, that currency can be debased by inflation or the money printing press. True, but markets do not seem to impose the same penalty on inflation risk that they do on default risk.
There are two main take-aways from this. The first, of course, is that if you don’t have a proper central bank you ought to keep your debt profile slim so as not to attract too much attention to your vulnerability. This worked for Germany, whose Bundesbank was similarly forbidden by charter from printing money to buy government debt. Not borrowing too much is good advice but not terribly helpful in the current circumstances.
The second is that Europe needs a democratic way in which to agree to monetize or otherwise write down its debts. Failing that, the risk is that the domino-style run on government credit becomes self-fulfilling, as we’ve seen is the risk with ever larger sovereign borrowers like Italy being weighed by the markets and found wanting. This ultimately will break the euro, probably at about the point when Germany realizes it is picking up France’s dinner check.
This is not an argument in favour of suppressing markets by banning short selling or other measures, as is so often the impulse in Europe. Those arguments are raised by people, be they politicians or investment bank CEOs, who want to be insulated from the consequences of their own decisions. It is instead about clarity about who pays.
Europe suffers from unclear lines of accountability. There are easy fixes for that, but imposing them quickly will be difficult. That is certainly how markets are trading, and the result may be a self-fulfilling fracturing of the euro.
At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.