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.