Euro crisis in a nutshell

In Uncategorized on 16/11/2011 at 5:55 am

Best concise explanation I’ve read.

What changed is not … political or economic fundamentals but how investors perceive … debt. For most of the euro era, investors considered euro-zone sovereign bonds to be risk free. Prices and yields would fluctuate but anyone who held an Italian bond to maturity assumed they would get back 100 cents on the dollar (or euro), as they would for a US Treasury or British gilt. This was always something of an illusion. Risk-free can only apply to the debt of country that controls the currency in which it borrows. A holder of its bond knows he can always sell it to someone else, in the last resort the central bank. As Chris Sims of Princeton points out, such bonds may have inflation risk but not counterparty risk.

That has never been true of a euro-zone member country, but investors happily ignored the fact, thanks in part to the European Central Bank which treated all sovereign bonds equally in its refinancing operations. (See our analysis here.) It no longer can. Investors who once classified their sovereign bonds as risk free must now treat them the way they might a bond issued by a railway company or an electric utility (i.e. as “credit”) and have concluded they own too much.

A staggering amount of debt must now migrate from the portfolios of investors who want only risk-free debt to those of investors comfortable treating it as credit. That is why yields on Greek, Portuguese and now Italian bonds have shown only fleeting responses to multiple bail-outs, austerity programmes and rounds of buying by the European Central Bank. Investors have treated the dip in yields that follow each announcement as an opportunity to lighten up.

  1. Still can relax lah. STI still above 2000. Wait until STI goes below 1800 then talk lah.

  2. 1) This is framed in the media as a sovereign debt crisis. It is not, at least not from a Singaporean point of view. Iceland going bankrupt meant diddly squat to Singapore. As far as Singapore is concerned, this crisis is a European *BANKS* solvency crisis. From a Singaporean point of view, fear not the nations defaulting. Think Iceland or Argentina going bankrupt. Nothing to be afraid of. Instead, think of Lehman going under. Who knows where the next minibond landmines lay hidden. Who would have thought MF Global would go under and investments totally unrelated to Europe can get stuck.

    2) The roots of this crisis is not so much the Euro, but the fact that the decision makers of ECB is hamstrung by an electorate increasingly controlled by pensioners. Pensioners dont mind recessions or high interest rates. Pensioners mind inflation. So ECB cant fire up the printing press and solve the crisis by devaluing the Euro. Or make American style trillion dollar bank bailouts.

    3) Solution is simple. End democracy. At least strip the pensioners of their vote. Start printing, crisis averted. Of course, when this process starts, it will end with the Third Reich.

    4) Otherwise, crisis continues. None of the PIIGS can democratically implement the austerity measures required. They will need more bailouts over and over again. Eurozone will stay stuck in recession, and the pensioners will love it.

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