Bond Market to Periphery Politicians: You Don't Matter

And it seems it is right. For now.

New European Union Flags For Croatia
Photographer: Simon Dawson/Bloomberg

On Thursday last, Ireland sold 10-year debt into the market at a record-low yield of 0.817 percent. 

In a world of negative interest rates and central bank buying this might not seem that much of a surprise, but there are two factors that you would expect the bond market to take account of when pricing Irish debt.

Firstly, there is the risk to the Irish economy from the upcoming Brexit referendum. But, perhaps the bond market can be forgiven for not pricing that risk into Irish debt, as it has so far failed to make any impression on U.K. sovereign debt

The second factor is much more fundamental, and one which requires some explaining. Ireland has no effective government at the moment, and hasn't had one since February's election. Further, with talks on forming a governing coalition going nowhere, a new election now seems likely. Such political uncertainty should lead to bond market jitters, right? Wrong:

Indeed, Ireland is not alone in this regard. Another euro area member state, Spain, held elections in December and has been unable to form a government since. That country is also now facing the prospect of another election and, once again, the bond market doesn't care. 

Even more remarkable is that the relative performance of the debt of countries in political crisis is no worse than those in the euro area with stable governments. Here's the spread between the Irish and the German 10-year bond so far in 2016:

The obvious answer is that European Central Bank buying is the reason for the benign bond-market conditions. But there also seems to be something more fundamental going on.

To explain what that is, we can look to an idea posited by Thomas L. Friedman in his 1999 book "The Lexus and the Olive Tree," and further expanded on by Dani Rodrik, Ford Foundation Professor of International Political Economy at the John F. Kennedy School of Government at Harvard University, in his 2000 paper, "How far will international economic integration go?"

At the most fundamental level, the idea is that increasing globalization, or "international economic integration" as Rodrik called it, leaves nation states with a trilemma. In order to achieve international economic integration, states have to give up political power. 

Pick two, any two
Pick two, any two
Rodrik (2000)

Or, as Friedman puts it:

Once your country puts on the Golden Straitjacket, its political choices get reduced to Pepsi or Coke—to slight nuances of tastes, slight nuances of policy, slight alterations in design to account for local traditions, some loosening here or there, but never any major deviation from the core golden rules.

For Ireland and Spain right now, the golden straitjacket is the euro. The European Central Bank, through both its purchase programs and the rules it attaches to them in order to keep countries in line, controls how tight the jacket is. One look at Greece shows what happens when a country that has put on that straitjacket tries to slip it off.

At the moment, with low interest rates and asset purchases, that straitjacket is not too uncomfortable, but Professor Rodrik warned, when contacted by Bloomberg, that "The golden straitjacket can sometimes become too constraining and domestic politics may be able to tear it off....The domestic political threat arises when and if the ECB pushes interest rates higher despite considerable slack in those weaker economies."

So, maybe for the bond market, they can only ignore euro area national political dramas for now. 

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