Financial markets and the governments of advanced economies around the world are inextricably tied together in an unbreakable marriage, a Brookings Institution paper reported. The two sides need each other. Governments borrow huge sums of money and, for its part, the financial system requires a large base of safe, liquid assets to function efficiently. In some times and places, however, that marriage is very troubled. Right now, the Eurozone is a prime example. The financial markets do not seem to understand or trust the governments and those sentiments are returned by many policymakers, including key ones.
My previous paper, “Why can’t Europe get it right the first time… or the second… or the third?”, laid out the painful political constraints that explain some of the confusion and apparent irrationality in the government responses to the Euro Crisis. This paper tries to explain why the markets react as they do to those government decisions and signals. It addresses these key points:
Eurozone sovereign bonds lie on a spectrum between national bonds and Eurobonds, from a financial perspective
Changing perceptions of where bonds are on that spectrum can substantially alter their value, which explains why prices of bonds of troubled countries are so closely linked
Bond prices are inherently more affected by risk perceptions than by upside potential
Eurozone governance is so complicated that it is natural that markets misjudge policies at times
Speculation in troubled eurozone bonds plays a significant role, but one which is often exaggerated
Eurozone sovereign bonds lie on a spectrum between national bonds and Eurobonds, from a financial perspective.
The eurozone is somewhere between a grouping of national governments and a single, larger entity. National governments of its 17 countries make most of their own decisions, as nation-states have since the Treaty of Westphalia in 1648 established the basic rules of the road for interactions between countries. However, they have ceded monetary policy decisions to the European Central Bank (ECB) and have agreed upon a host of other common economic arrangements. These include business regulations of various kinds, common trade policies, and even transfers of aid to weaker regions within the eurozone. There are also agreed caps on fiscal deficits, although these caps were largely eroded a few years into the eurozone’s existence and were temporarily blown away by the financial crisis and the severe recession that followed.
As a result of this hybrid nature, investors in, say, Italian debt do not know definitively whether they are holding the debt of a stand-alone country or a kind of “Eurobond” that reflects the creditworthiness of the entire zone, or something in between. (Eurobonds are a financing mechanism proposed by many analysts that would be backed by the joint guarantees of all the eurozone members, including Germany and the other strongest credits in the zone.) For much of the previous decade, eurozone government bonds traded at very similar interest rates, suggesting that the markets really thought they owned something much like a Eurobond. Once that complacency was shattered, interest rates diverged and now vary sharply within the eurozone, but are still not as disparate as they would be if there were no expectation of help from the richer eurozone countries to the poorer. Read more.
Location