The penny drops at last in Europe

Allister Heath
IN a rational market, risk as well as return is at the forefront of investors’ minds. They demand a high rate of interest to lend to risky companies, individuals or countries – and a low one to invest in safe havens.

The problem during bubbles is that investors drunk on excessive liquidity – and who thus suddenly have more money than sense or profitable opportunities at their disposal – stop making such judgments. They start to act as if all assets are equally riskless. The once massive gulf between yields on junk bonds and those on safe investments shrank to ridiculously low levels as the bubble blew out of control five years ago.

The race for yield was predicated on the faulty assumption that overall risk had diminished permanently, as a result of globalisation, financial innovation and low inflation. The collapse in the real cost of borrowing was seen as proof of progress, rather that the manifestation of the mother of all bubbles in the bond markets (caused in the first instance by central banks’ encouragement of excessive liquidity, combined with government-created moral hazard).

Dodgy, over-leveraged deals could raise funds on great terms – as, infamously, could sub-prime borrowers. The Eurozone was affected by this global bubble, of course, but the launch of the euro and the accompanying propaganda from the political establishment triggered an even more disastrous mispricing of risk across the continent. Prior to the single currency’s launch, it (very sensibly) cost far more for risky countries such as Italy or Spain to borrow than it did for Germany.

But following the launch of the single currency, all government-debt became denominated in euros – and slowly everybody started to treat it as pretty much alike. After all, there was already a one-size-fits all official base rate fixed by the European Central Bank – why not the same with government bonds? The fact that this was a monetary union, not a fiscal union, was forgotten; despite obvious violations, many chose to believe the European treaties’ rules on fiscal prudence. They also convinced themselves that countries would be bailed out in extremis to preserve the euro, with the funds presumably magicked out of thin air.

What this meant was that mismanaged countries such as Greece were able to free ride on the credibility of countries such as Germany when it came to bond yields. The weak nations’ cost of borrowing collapsed, delivering what many supporters of the euro wrongly saw as a permanent free lunch. This had a huge effect on the likes of Spain, pushing down mortgage rates and triggering a massive house price bubble. In reality, the creation of the single currency meant that nations were more likely to go bust (and were thus riskier) because they no longer controlled their own currency. There used only to be an inflation and devaluation risk; now there is also an actual default risk. Yet instead of going up, the cost of borrowing collapsed.

The best way to understand the current increase in Italian, Spanish and increasingly French yields is that risk is finally starting to be priced rationally again – markets now realise that some countries are more likely to default or quit the euro than others. Default doesn’t necessitate real insolvency: Italy is a rich country with lots of assets. Yet a country can go bust if its political system is broken or its electorate wedded to silly policies.

But this increased realism is already turning into panic. Investors are beginning to comprehend that debt levels in several countries are simply not affordable at proper interest rates. As the penny drops, it will become ever more obvious that the euro’s launch was one of the greatest political and economic blunders of modern times.
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