Having followed the ups and downs of the financial markets for over 15 years now, I have come to the sobering conclusion that, rather than reason, fad and storytelling are what really matter. The latest example is Greece and its debt, which may or may not cause government bond markets to go into a tailspin and which even calls into question the existence of the euro.
Greece, once the beacon of western civilization and founder of the Olympic Games, with a population of 11 million, and roughly the size of a city like Rio de Janeiro, will have an estimated debt-to-GDP ratio of 120% in 2010, and a public deficit of EUR 26 billion (around 10% of its GDP). EUR 26 billion, or USD 36.4 billion, is roughly the US government deficit for a week. How come therefore that many market participants echo the Roman poet Virgil: “fear the Greeks”?
The scenario goes something like this: once Greece defaults, the next shoe to drop in the so-called 'PIIGS' universe (a rather disrespectful acronym for Portugal, Ireland, Italy, Greece and Spain), will be Portugal. And once the frenzy reaches the larger countries like Spain or Italy, the days of the euro will be numbered. Although it has some appeal, and one could even draw a parallel with the 2008 situation (five Wall Street investment banks at risk then, and five European countries at risk now), there are several objections to this scenario.
Our first objection relates to the PIIGS concept itself. Currently many market participants are stressing Italy's “unbearable” debt-to-GDP ratio of over 100%. What is often forgotten though is that this has been the case for Italy for much of the last 20 years. In fact, for much of this period, Belgium had an even larger debt-to-GDP ratio, and there is currently no 'B' in the 'PIIGS'. Spain, which is another country, perceived as a major risk, has a debt-to-GDP ratio that is still far lower than that of the US or the UK; not to mention that of Japan.
Our second objection relates to the nature of the euro itself. If only market participants and economists would have had a say on the common currency, it would likely never have come into existence in the first place. However, the euro is, first and foremost, a political project, which so far has proven all its critics and doubters wrong. Although that does not in itself mean that the euro’s stability, or even its future, is assured. However, we believe that solving the Greek debt crisis is primarily a political issue. Hence, where there is a political will, there is a way.
Unless European politicians are willing to destroy, what has been painfully built in Europe over the last twenty years, they will not let Greece fail. One might argue that there is a moral hazard here and such a rescue would incentivize governments of other countries to act in a profligate way, ultimately hollowing out the European Monetary Union Stability Pact. We need to bear in mind though that even with an implicit guarantee of financial more solid European governments, the interest rates of profligate countries will remain higher. Moreover, the memory of Lehman Brothers, which was not rescued for exactly this moral hazard argument, and the costs following its bankruptcy are still vivid in Europe.
All in all, the concerns surrounding Greece and other countries' sovereign debt illustrates how odd the government bond market currently is and how artificially low interest rates are. Once the focus of market participants moves from Greece and the 'PIIGS' countries, where will it turn to next? To the UK? To Japan? Or even to the US?
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