During the global financial crisis, after each acute phase, there would be a period of relief in which conditions returned to a semblance of normalcy, and policymakers and investors carried on as if acting as if all was well would make it so. Unfortunately, positive thinking provided only temporary relief from the undertow of rising defaults and continuing deterioration of bank balance sheets.
A similar dynamic may be underway in Europe, but potentially on a more extended timetable. The upheaval of May had a familiar, vertiginous feel of 2008: are these sudden market shifts the beginning of something much worse? Even though key political actors shows a fair bit of disarray, and the responses were deemed to have meaningful shortcomings, it looked as if Mr. Market was very keen to find an excuse, any excuse, to pull back from the brink. So a rescue package that looked circular (stressed states helping bail out themselves) and unduly dependent on an increasingly skittish Germany, plus not very convincing stress tests, nevertheless gave the markets a real boost.
Or have they The euro has slipped from recent highs, and perhaps more important, the bond markets are signaling considerable concern. As Wolfgang Munchau points out in the Financial Times:
While the Europeans are celebrating the end of the financial crisis, something strange is happening in the bond markets. The gap in the yields – the spread – between the 10-year bonds of peripheral eurozone countries and Germany has been growing at an alarming rate. It is now close to the level that prevailed in the days before the European Union decided to set up its bail-out fund in May.
Last Friday, the spreads were 3.4 per cent for Ireland, 9.4 per cent for Greece, 3.4 per cent for Portugal, and 1.7 per cent for Spain. The yield on 10-year German bonds is currently ridiculously low, about 2.3 per cent. The financial markets somehow regard Germany as a paragon of virtue, stability and sound financial management, and are happy to demand virtually no return on 10-year investments. If the bond markets were ever returned to normal, and if the spreads were to persist, peripheral Europe would find itself subject to an intolerable market interest rate burden…..
Spain is probably fine for the time being. Portugal’s combined private and public sector debt adds to well over 200 per cent of gross domestic product. In Ireland, the main problem is the banking sector. The economists Peter Boone and Simon Johnson have done some of the maths and found that the total amount of debt likely to end up with the Irish government amounts to about one-third of GDP. They concluded that with 10-year market rates at current levels – close to 6 per cent – Ireland is effectively insolvent. To correct this Ireland would need to generate spectacular rates of future growth. But do we really believe that the Celtic Tiger trick can be replicated? Was the presence of a global financial bubble not inherent in that model?…
In Greece, the adjustment programme is going well – much better than anyone had hoped. Some of the people directly involved with whom I have spoken are almost euphoric in their praise for the Greek government’s approach to the crisis. I also take the government’s commitments seriously, certainly as regards fiscal adjustment.
I am less optimistic when it comes to structural reforms…
To guarantee the solvency of the eurozone’s periphery would require not a few quarters of solid growth, but an entire decade. I am at a loss to understand how countries still recovering from an enormous asset implosion can generate so much growth.
The self congratulatory posture of the European officialdom after the financial markets responded well to their various fixes did have a Mission Accomplished feel to it. Only time will tell whether Munchau’s sober call is correct.
P. S. Some European readers take affront when this blog suggests that either the eurozone experiment or certain EU nations are due for quite a bit of rough sailing. A frequent assertion is that parties that point out the structural challenges facing the currency union (the very same challenges acknowledged by its creators) are “anti European.” Folks, if you look at the history of this blog, we’ve been vastly rougher on the US and in particular, the Bush-Obama economics policy team than the eurozone.