A response to Roger Altman: Roger Altman of Evercore partners is a friend of mine, a distinguished public servant and a respected financial expert. But his column “Blame bond markets, not politicians, for austerity” is, in my view, gravely mistaken. Let me quote the first two paragraphs, since they go to the heart of the matter:
Criticism of austerity has reached ferocious levels in Europe. Increasingly, it carries a moral tone, portraying the stronger north, especially Germany, as forcing harsh policies on to weaker nations. Opponents of austerity argue that the north is demanding fiscal tightening and labour market reforms from these stricken states in exchange for vital lending from entities such as the European Central Bank. They see it as kicking economies when they’re down.
This is an important debate, but critics are forgetting a key point. It was not Angela Merkel, chancellor of Germany, or other political leaders who pushed austerity onto Italy, Spain, Greece and the others. It was private lenders, beginning in the autumn of 2011, who declined to finance further borrowing by those countries. Then they stopped financing portions of their banking systems. In other words, markets triggered the Eurozone crisis, not politicians. The fiscal and banking restructuring that followed was the price of rebuilding market confidence.
I have written on the relevant points several times…. Here are the prospective net public debts of the UK and Spain, according to the IMF’s World Economic Outlook database.
Here, as well, are the interest rates on German, Spanish and UK 10-year government bonds, in which, of course, the UK looks far more like Germany not Spain.
So what explains this extraordinary divergence between the long-term interest rates of two countries with very similar debt dynamics?… The UK is a sovereign country, with its own finance ministry, central bank and floating currency, while Spain has a subordinate government inside a currency union that has no shared treasury and a super-national central bank (the European Central Bank). Suppose holders of a government’s debt believe that it might be unable to roll it over on reasonable terms. Then they would rationally fear an outright default. They will demand an interest rate that protects them against this risk…. But, at an elevated interest rate, the government will be driven into default, making the prophecy of doom self-fulfilling. This is the danger of “multiple equilibria”. Olivier Blanchard, economic counsellor of the IMF puts this as follows:
At high levels of debt, there may well be two equilibria, a ‘good equilibrium’ at which rates are low and debt is sustainable, and a ‘bad equilibrium’ in which rates are high, and, as a result, the interest burden is higher, and, in turn, the probability of default is higher. When debt is very high, it may not take much of a change of heart by investors to move from the good to the bad equilibrium.
Preventing that is one of the jobs of central banks. Indeed, the Bank of England was created more than 300 years ago, in order to manage the market in public debt. A central bank guarantees liquidity in the market for sovereign debt. That hugely reduces the risk of a sudden default. That, in turn, gives confidence to lenders. The principal reason why interest rates in Spain are so much higher than those of the UK is that no such lender of last resort existed for the former. Spanish debt was subject to liquidity risk and, in the crisis, when liquidity risk looked significant, markets priced it accordingly….
Mr Altman goes on to say:
Today, the question is whether the rescued European borrowers, and the Eurozone itself, have regained sufficient market confidence to permit an easing of the fiscal tightening that took effect a year ago. This is more a market question than a political one. Italian and Spanish bond yields, among others, have nearly returned to normal levels. We do not know how solid this investor confidence is, but this fall in borrowing costs suggests that some easing can be done, provided that it proceeds carefully and does not trigger another market boycott.
This, too, misses the point. The decline in yields on Spanish debt, shown so clearly in the chart, dates almost precisely to 26th July 2012, the date on which Mario Draghi, president of the ECB, told an audience in London that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” This statement, in turn, led to the announcement by the ECB on August 2nd 2012 of “outright monetary transactions” which would be aimed “at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy”. Rightly or wrongly, markets concluded that the risk of an outright default on Spanish bonds had largely disappeared. This, in turn, pushed the price of bonds from a bad equilibrium to a somewhat better one. Of course, as bond yields fell, the government did, indeed come to look more solvent, justifying the markets’ greater optimism…