By Paul De Grauwe
The crisis that started in Greece culminated into a crisis of the eurozone as a whole. It may find a temporary resolution. But even then, it will leave an important imprint on macroeconomic management within the eurozone. In particular, the crisis has made clear that the financial markets are dictating and will continue to dictate the speed with which the eurozone governments are reducing their budget deficits and debt levels. In other words, not the governments but the financial markets will force exit strategies in the budgetary field.
The believers in market efficiency are cheering. The markets are going to discipline profligate governments, forcing them back into orthodoxy. The reluctant governments failing to follow the market’s order will be punished with higher risk premia on their bonds. In the end the market will force them to return to the stable of budgetary orthodoxy.
The view that financial markets are a reliable device forcing agents and institutions to be disciplined is popular again. This is surprising. After all, can’t we conclude from the recent past that, if anything, financial markets have failed dismally as a disciplinary device?
Before the subprime crisis, financial markets systematically underestimated risk, leading to excessively low risk premia which in turn gave wrong incentives to millions of investors who took on too much risk. Since the eruption of the crisis, risk premia have increased everywhere.
Are we so sure that the risk premia that the markets are now imposing are the right ones? If for years the markets could underestimate risk, can’t they also overestimate risk systematically afterwards? The answer is yes, of course.
It is even worse. The risk aversion that markets today exhibit vis-à-vis government debt creates a self-fulfilling dynamic that tends to increase the risk inherent in government debt. Let me elaborate on this.
First, it is important to keep in mind that the main source of the sudden increase in government debt in the eurozone (and elsewhere) is the preceding unsustainable explosion of private debt of households and even more so of financial institutions.
Since the eruption of the crisis, the private sector has been gripped by the need to improve its balance sheets by saving more and by deleveraging. Balance sheet improvement of the private sector, however, was made possible because governments made it possible. The fact that governments started saving less and took on more debt was the condition that allowed private sector agents to improve their balance sheets.
When financial markets today force governments of the eurozone (and elsewhere) to exit their strategies of budget deficits and debts, they cut the branch on which they are sitting. By forcing an early exit strategy, financial markets force private agents to intensify their attempts at reducing debt levels by saving more and by selling assets. This is likely to be self-defeating and to lead to a new recession. And as always, recessions lead to deteriorations of government budget deficits.
The vicious circle has come around. By forcing governments into early exit strategies, financial markets increase the risk that government budget deficits increase, raising the risk against which financial market participants wanted to protect themselves against.
There is a second self-fulfilling mechanism that will affect government budgetary policies in the eurozone. When investors start dumping, say, Spanish government bonds, they raise the interest rate on these bonds and force the Spanish government to reduce its budget deficit.
This is likely to produce a downturn in Spanish economic activity which in turn affects Spain’s trading partners. The latter see their exports to Spain decline, leading to a decline in their national production. Through this channel government budget deficits increase in the countries that trade a lot with Spain. Thus by selling Spanish government bonds investors also increase the riskiness of the government bonds in other countries of the eurozone. Investors start selling these bonds also.
The essence of the problem is that investors who sell government bonds of one country do not take into account the spillover effects these sales have on the riskiness of the government bonds of the other countries. This problem of risk contagion is high in the eurozone because member countries trade intensely with each other. Investors trying to avoid risk, create more risk elsewhere in the eurozone.
In addition, by forcing an early exit strategy on one member country of the eurozone, other countries that need not exit are also forced to do so. The probability of a new recession in the eurozone increases. There is only one way to solve this problem. This consists of the governments of the eurozone coordinating their budgetary policies better. Unfortunately, there is very little prospect for this to happen soon. As a result, financial markets, that are ill-suited to do so, will continue to dictate budgetary policies in the eurozone.
Paul De Grauwe is professor of economics at the Catholic University of Leuven and associate fellow at the Centre for European Policy Studies.
Related reading:
Greece: It’s not all tragedy Michael Burda, Vox
Spain’s woes and Germany’s export model come mean double dip Edward Harrison, Naked Capitalism
FT Alphaville
FT Money Supply
