One of the proudest achievements of the euro project was ensuring government borrowing costs converged at the lower levels enjoyed by Germany rather than the higher yields paid by its less fiscally disciplined neighbors.
That’s over. Done. Finished. Just as the bailout of the banking system produced a plethora of unintended consequences, so the European Union’s decision to pledge almost $1 trillion to defend the single-currency project will unleash a series of undesirable aftershocks. Here are some that are inevitable.
It’s Solvency, Stupid, Not Liquidity.
Cast your mind back to March 17, 2008. Richard Fuld, then chief executive officer of Lehman Brothers Holdings Inc., said the Federal Reserve’s decision to expand the list of firms it lent money to “takes the liquidity issue off the table.” Six months later, Lehman was dead.
Europe can’t solve the problem of too much debt by adding yet more debt. Robbing Helmut to pay Stavros is a recipe for disaster. Giving Greece a helping hand over its bond repayment humps doesn’t fix the underlying crisis -- Greece is insolvent, and some of its peers aren’t in much better shape. That’s a far bigger worry for bondholders than any short-term cash-flow issues.
The Meanness of the Mean
Moral hazard, which came to the fore as governments admitted that some institutions are too big to fail and will always get bailed out no matter how egregious their financial transgressions, now attaches to governments themselves.
Greece lived beyond its means, and got rescued by the EU. The irresistible logic is that all the debt of the euro region is now jointly and severally guaranteed -- exactly what the euro’s founders sought to avoid.
The inevitable market response should be to drive bond yields to some average level that is higher than the previously subdued bund yields, now that Germany is effectively on the hook for the debt of all its currency neighbors.
The End of AAA
A similar analysis applies to credit ratings. Germany is a AAA borrower in its own right; if you saddle it with the debt obligations of Greece, Portugal, Spain and others, its grading will have to be lower than the top level. It remains to be seen whether the rating companies, which are under almost daily regulatory threat from European governments for finally doing their job and downgrading weak borrowers, have the backbone to follow through on this logic.
All the President’s Men (Well, One of Them at Least)
“We will not change our collateral policy for the sake of any particular country,” European Central Bank President Jean-Claude Trichet said on Jan. 15. Less than four months later, he scrapped the eligibility rules as the prospect of Greece losing its remaining investment-grade rating threatened to prevent Greek banks from swapping their government debt for ECB cash.
In March, Trichet said the following: “I don’t trust that it would be appropriate to have the introduction of the IMF as a supplier of help.” The bailouts cobbled together in recent weeks feature the International Monetary Fund front and center as a significant donor.
Last week, the first question at the press conference following the ECB’s monthly meeting was whether the topic of buying government bonds had been debated. “We didn’t discuss this option,” Trichet said. You could hear the bond market swooning -- until May 10, when the Bundesbank was forced to lace up its bond-buying boots and lead a market charge to drive down government borrowing costs.
Trichet, one of the most fiercely independent central bankers you could hope to meet, seems to be losing control of his own destiny. Moreover, comments by Bundesbank President Axel Weber, who told the Boersen-Zeitung newspaper that purchasing debt poses “significant” risks, hint at an unprecedented disharmony in the ranks. The ECB inherited the credibility of the Bundesbank; a central bank that doesn’t stick to its guns will have a hard time resisting political interference.
Those of us old enough to remember the European currency unit, a virtual measurement that acted as the predecessor of the euro, may recall the debates about whether it would be a “hard” or “soft” currency. It all depended on whether its members took the opportunity to enjoy an export-boosting devaluation before adopting a shared unit of exchange.
For a decade, the investing world has respected the euro as a worthy successor to the deutsche mark. Instead, it turns out to be more of a drachma; it should start to trade like the runt of the currency litter rather than one of the top dogs of foreign exchange.
(Mark Gilbert, author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable,” is the London bureau chief and a columnist for Bloomberg News. The opinions expressed are his own.)
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