The Sovereign Debt Crisis:


An attempt to decipher the message conveyed by markets in disarray.


The increasing volatility of markets makes the interpretation of its fluctuations particularly difficult, and I therefore fully recognize that to undertake such an exercise is hazardous.


It is common to attribute to markets a capacity for “anticipation” which may be, in part, explained by a tendency towards the self fulfilment of the rationales that underpin the execution of market transactions, similar to the phenomenon that was recently pinpointed in the context of “ratings”.


Let us first recall the objective “facts” concerning recent sovereign debt market developments: two separate trends are noticeable in the evolution of interest rates.


-          A significant reduction in “benchmark” rates in the USA, Germany, U.K., Japan and Switzerland.

-          A considerable widening of spreads between EMU sovereign issuers.


How should one interpret these trends?


The fall in “benchmark” rates carries two distinct messages:


-          Capital flows seeking “safe haven” investments induce lower rates (higher prices) resulting from the mechanical impact of an increasing “demand”.

-          The anticipation of a new economic contraction reinforcing the likelihood of a “deflationary” scenario.


The second message tends to reinforce the first because the purchase of Government securities of “benchmark” issuers attracts frightened investors who are ready to accept negative interest rates to ensure “nominal” capital preservation. (10 year Bund rates are below German inflation).


The widening of spreads between Eurozone issuers carries also a dual message:


-          The first is the mirror of the one mentioned here above: dumping of securities of peripheral issuers induces lower prices (higher yields) resulting from the mechanical impact of an increasing “offer”.

-          The second reflects the perception of a growing differentiation of risk associated with holding securities of these issuers.


It is mainly on this last point that I wish to develop my arguments, as I believe that there is an implicit underlying message that the market is trying to convey:


In fine, the evolution of the market reflects the “lack of credibility” of the measures decided to date to deal with the crisis (including those agreed at the recent July 21st.Eurozone Summit) and, consequently, the anticipation of “the probability of the implosion of EMU”.

Before addressing the heart of the question, let us avoid raising the question of the responsibility of Rating Agencies in the process: it is clear that the market is not paying any serious attention to the AA ratings of Spain, Italy and Belgium or even to the AAA ratings of France or of the EFSF, as, otherwise, it would be difficult to explain spreads of 400/200 or 80 basis points respectively, which are the levels at which these securities trade currently relative to 10 year Bunds. There is no historical precedent for spreads of this magnitude between issuers rated within such a tight band. Ministers Baroin and Schaüble must surely rejoice that their appeal on this subject has been so well heeded!


Let us now turn to the “credibility” of the measures already taken as well as those currently envisaged: If markets were genuinely convinced that EMU countries will do “all that is necessary” to ensure the Euro’s stability, that the Greek case was indeed “unique” and that “all other EMU countries will honour scrupulously their financial obligations”, it would be very difficult to justify the rate differentials currently prevailing in the market. It is obviously not the case for reasons that are fairly easy to understand:


-          There is an inbuilt contradiction between surmounting the crisis by relying on economic growth and the implicit scenario – anticipated by markets – of a further economic slowdown (see above).

-          The ECB’s mandate (inflation targeting at or below 2%) and the budgetary discipline that it requires is incompatible with a demand led economic recovery.

-          Doubts surround the will and/or capacity to make significant progress towards further economic, financial and therefore political integration within the EMU/EU.

-          The structure of the EFSF (and the future ESM) and its dedicated resources are manifestly inadequate. How is it possible, if either Spain or Italy were to seek assistance, to reconcile the operational credibility of the Facility with its own bylaws which exonerate from future commitments any Member facing difficulties?


Failing a satisfactory and urgent answer to these questions, it is to be feared that it is the second leg of the message - the (at least partial) implosion of EMU - that will prevail.


Indeed, one possible explanation for the widening of spreads between issuers is that it reflects a very approximate and subjective idea of what a realignment of new “national currencies” resulting from the disintegration of the Euro would look like.


Such an interpretation is wholly compatible with the capital flight towards the safe havens provided by the issuers of countries mentioned here above. Indeed, each of them, with the exception of Germany, have retained their monetary sovereignty and therefore the capacity to monetise their debt expressed in local currency as well as resorting to devaluation in order to avoid default. This is how – surprisingly – the U.K. is among the beneficiaries despite the fact that its currency has lost 25% of its value since the beginning of the crisis; it also underpins the view that the U.K. economy is facing increasing headwinds.


Germany can be considered as the anchor of the Euro and therefore potentially in the best position to ensure the “continuity of contracts” between the € and a putative “new mark”. Based on the current level of spreads, it would be most likely joined immediately by the Netherlands, Austria, Finland and Luxemburg and, with greater difficulty by France as well as Belgium if, regarding the latter, it had overcome in the mean time its internal political crisis.


Thus, a new (two speed) European Union could emerge in which the core remaining EMU Member States would significantly deepen their integration on a resolutely “federal” model. They would constitute the “European Community” within which the “acquis communautaire” would be applied without any exception or derogation. Other EU countries would remain as Members of an “intergovernmental” European Union with a vocation to join the Community when their economic and financial situation would allow them to endorse and comply with the entire common “acquis”.


In conclusion, insofar as this personal interpretation of the signals conveyed by sovereign debt markets has any rational foundation, it indicates that “it is not too late but high time” for the political authorities to undertake drastic measures to further integration within EMU.


Markets are unlikely to grant a reprieve until late October, when President van Rompuy is due to submit his recommendations on implementation of the recent Summit agreements. In this regard, all the main actors should take a leaf out of Premier Zapatero’s book and postpone their summer holidays in order to devote their efforts to the problem on hand. Without rapid and determined action, markets are liable to create an un-retrievable situation in which an uncontrolled implosion of EMU would lead most likely to the end of the European Union itself.


Brussels, August 3rd 2011


 Paul N. Goldschmidt

Director, European Commission (ret); Member of the Thomas More Institute.
















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