Wednesday, December 28, 2011

The Eurozone Crisis: Market Correction?

The Eurozone crisis is about markets behaving like markets again. Since 1999, when the euro was launched, markets have systematically mispriced sovereign debt by assuming that all Eurozone countries were equally credit worthy. Markets thus lost their self-corrective character: when countries borrow heavily, they are punished through higher bond yields. But when all countries borrow at the same rate, there is no penalty for profligacy. Our current crisis is a result of markets trying to price debt properly again. 

The graph below shows the cost of borrowing for Eurozone countries. In the early 1990s, there were two types of countries. There was a core whose governments borrowed at +/- 8% a year, and there was a periphery which borrowed at +/- 13% a year. There was also Greece, in a category by itself, with interest rates around 20%. Over time, however, that discrepancy disappeared and what used to be a 100% difference between the two extremes turned into a 15% difference by 2001. Everyone was more or less the same. 

In theory, this convergence in yields was due to converging fundamentals: low inflation, stable exchange rates, shrinking budget deficits and declining public debt levels. But in truth, there was no such convergence, not even superficially. Debt, for example, was highly variable as early as 2001 with Luxembourg boasting a debt over GDP ratio of 6.3% and three countries (Greece, Belgium and Italy) being over 100%. Debt levels remained too variable throughout the decade to justify such a convergence in yields. 

Not only were debt levels variable but so were deficits: in 2001, there were countries such as Luxembourg (+6.1%) or Finland (+5.1%) with high surpluses and countries such as Greece (-4.5%, revised) or Portugal (-4.3%) with large deficits. Such discrepancy again persisted throughout the decade with some countries running chronic deficits and others running chronic surpluses. 

Convergence thus made no sense. Even without knowing anything about the 17 countries that make up the Eurozone, a casual look at the most basic public finance statistics would suggest that these countries should have different credit ratings and different borrowing costs. Yet they did not – at least not until late 2008. That’s when markets started being markets again, except that it was also a time when markets were very cautious and risk averse. So rather than a return to pricing risk correctly, markets just went berserk. But fundamentally this is a crisis of markets trying to figure out how to price sovereign debt properly. 

Why does this matter? For two reasons. First, it is important to conceptualize the Eurozone crisis properly and to understand that it is essentially a correction after a decade of debt mispricing. Second, it is heartening to know that markets are functioning again, even though in their present mind, they are probably excessively risk averse. In a time when European politicians are trying to design new institutional structures to control budget deficits and to punish profligacy, markets are showing that they can perform this task. When markets were asleep on the wheel, political controls would have been worthwhile. But markets are awake now and, while they may make other mistakes, they are unlikely to assume again that all European debt is the same. And so the challenge that so vexes Europe – how to lend money to the periphery with proper strings attached – may soon end up being a moot point as long as markets behave like markets again. 


  1. Normally I agree totally with your analyses. This time, I have some doubt, but maybe there is just a misunderstanding. Your text sounds as if markets behaved irrationally in the first years of the Monetary Union. I am not sure whether this is a correct perception.

    I am not a market expert, but I assume the markets work both on real (statistical or other) data and on expectations. As far as the real (statistical) data are concerned, they did show some degree of convergence, including for Greece, around the time of the establishment of the monetary union. (It became known only later that data for Greece were to a very large extent manipulated or simply falsified. At that time, this could hardly be suspected by the markets, as the data were supposed to be checked by Eurostat.) Later some of this convergence was lost, as some countries gave up or reduced the efforts that had helped to get them into the monetary union.

    If the markets did not react more quickly to this, I think it is due the fact that at the beginning they still believed that the rules of the monetary union would be observed and would function. In fact, politicians, especially in the European institutions (Commission and ECB), had always promised that these rules would "guarantee" the cohesion of the monetary union. As we know now (but could not know then), the rules have been thrown to the dustbin as they became inconvenient: The limits for deficits in the Stability and Growth Pact (the Excessive Deficit Procedure) were interpreted more and more generously, to put it mildly; in the end they were just ignored. The rule that there should be no financing of governments through the ECB was broken - the ECB holds now more than 200 bn of government bonds of problem countries. And the so-called no bail-out clause was circumvented by (in practice) not calling a bail-out a bail-out. That all this had to have very negative effects on market expectations seems understandable.

    So, did markets misprice risks in the past? With the benefit o hindsight, yes, but they had to price them not on today's information, but on the information they had at the time and on the expectations that politicians were eager to create with there promises.

  2. Nikos, I have to partially agree with the above comment. Although, as you point out with the series of charts markets were underestimating risk, but, this is much easier to say in hindsight. Most market participants thought that the EU mechanisms would work and Greece's economic situation was not so parlous based on the statistics at hand. However, the above poster fails to also admit that the pricing of debt was grossly underestimated not only in Europe but also the US and elsewhere. There was a glut of savings from China, Russia, Arab petro-states and elsewhere which indiscriminantly priced almost all debt as less risky that what it really was. I do not want to sound like a fence-sitter but I think the problem was partially understimation (and indiscriminate) pricing of debt risk by markets and partially rational market behaviour.

  3. The consensus seems to be that borrowing costs converged because the risk of currency devaluation was removed by the adoption of the euro.

    However, markets did not take this thinking a stage further until 2008 when it became clear default was a real possibility for most of Southern Europe.

    The nightmare consequences of the euro, giving up monetary sovereignty, deflationary spirals with no escape etc are only just being realised. It is hard to see how EMU can maintain its current structure over the medium term.

  4. @ Anonymous. Your point on statistics is well taken - but I don't think it's a good explanation. There were multiple revisions to Greek statistics, for example, but there was no impact of those revisions on yields. More generally, my point is that the variation in underlying government is too big to allow for a single bond yield - even if you add or subtract a few percentage points here and there, you still had wildly divergent fundamentals. And when it became clear that no one would enforce the excessive deficit rules, again on reaction on the bond market. So when new information did become available, it was not incorporated into the price. It was only in Sept 2008 that yields diverged - until then nothing mattered.

    @ Dionysi - Fully agree on the overall mispricing - the markets mispriced mortgages and government debt and many other securities. I don't buy that it was correct relative to information at hand - even if markets assumed that the EU would force convergence, there should have been at least *some* divergence to account for the possibility that things may turn out bad. So I agree that this mispricing was part of a broader mispricing.

    @ Anonymous2 - I think the removal of devaluation risk is important but was overblown. It's like saying that Zimbabwe dollarizing its economy should produce lower yields. It shouldn't and markets should have priced that better.

  5. For once, I completely disagree with your analysis.

    First, comparing current bond yields with what they were 20 years ago is meaningless: inflation was much higher then, and bond yields reflected that. The level of real bond yields is currently extremely high for several Euro countries. In the case of Greece, there is also this little haircut issue which makes bond yields meaningless.

    Second, compare the US with Slovenia for example. US: public debt 100% of GDP, public deficit 10% of GDP, 10Y bond yields 2%. Slovenia: public debt 39% of GDP, public deficit 6% of GDP, 10Y bond yields >6% (mid December). Does that make sense? No.

    For me, it is a complete misinterpretation to believe that this is a public finance crisis. This is first and foremost a crisis of the monetary union.

  6. @ economyeu:

    I respectfully disagree with you. Of course the different bond yields make sense, despite the debt situation. Your mistake begins with comparing an economy like the US with an economy like Slovenia, which is like comparing a Lamborghini to a Fiat 500. E.g. bond investors do not solely look at debts and deficits, but e.g. also at structural problems and economic strength when they try to evaluate investment risks.

  7. Nikos,

    I think your perception that "markets behaving like markets again" is misplaced for the following reason. Your perception "markets behaving like markets again" is based on markets acting like what you think is logical.

    On the whole markets do not care what you or any participants large or small think.

    Because the sole purpose of the markets is to clear trades efficiently.

    News and other available information create market perception among market participants which result in market orders from millions of participants.

    This difference in perception among actual participants is what makes price in real time and in perpetuity.

    If you were a participant back when the yields converged and wanted to short Greek Bonds and buy German bonds but was not allowed to participate because of regulation etc then this is a problem. Because the only opinion that counts to the market, a trade, was somehow prohibited from entering and expressing its opinion.

    But I can assure you there were no such restrictions back then.

    Looking back at any market you can make the argument that markets are inefficient because lets say gold back in 2000 was below 300 dollars while it is over 1500 now.

    If you can recognize that in real time you should shift your efforts to trading instead of writing blogs.

    Your blog is greatly appreciated though.


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