This is the interesting question that Morgan Stanley’s Vicenzo Guzzo asked a couple of weeks back. The key background details in question are what are known as the cross-country risk spreads. Now this may seem like a piece of technical obfuscation, so what exactly does he mean?
Well, one of the main consequences of the introduction of the euro has been the dramatic reduction in what are known as the ‘interest rate spreads’ on sovereign debt.
Again, what does this mean? Well the word ‘spread’ in this context, refers to the difference in long term interest rates charged between the stronger and the weaker economies. This difference for – say – Italy and Spain (using the 10-year German Bund as a reference rate) moved from over 6% in 1992 to less than 0.4% in early 1998. Since the late 90’s differences in rates across countries have varied slightly, but basically remained negligible. This is what the common currency does. The stronger economies underwrite interest rates in the weaker ones.
However, given the demise of the stability pact, the question Guzzo is really asking is whether this honeymoon can last. It could be that if national debt in the different member countries is allowed to continue to go its own way, these risks spreads could once more increase.
Up to now the only vague indication of such a possibility is the fact that on July 7, Standard & Poor?s lowered its long-term sovereign credit ratings on Italy to ?AA-? from ?AA? – while the the spread between 10-year BTPs and other Euro area government bonds widened only fractionally – and that on September 13, following major upward revisions to Greece?s deficit and debt measures, the same rating agency revised its outlook on the country from stable to negative (while re-affirming the long-term rating at ?A+?). Again market reaction was muted.
The big question is just how long this will last. Another one of those pesky ‘things to watch’.
I’m some years removed from my close relationship with a Bloomberg box, so any sense of how wide the spread is among US state debts? Spreads in the American muni market? That might be a good analog for what to expect within the eurozone.
Doug, I’m unfamiliar about how the debt of US states works. Is this really sovereign debt, or wouldn’t the federal government ultimately bail out, say, California if it was to default? Despite the common currency ultimately every Euro country is responsible for its debt (or rather irresponsible, as these things go these days).
Is that 6% in DM nominated debt or is that 6% the difference between Lira and DM debt cause the Lira devalued from time to time
“Is that 6% in DM nominated debt or is that 6% the difference between Lira and DM debt cause the Lira devalued from time to time.”
It is a 6% difference between what the German government had to pay to finance its debt, and what the Italian government had to pay. This difference is normally referred to as the risk premium. As you rightly indicate, the risk in question was primarily currency related, as the Italian government systematically devalued.
In principle this kind of risk disappeared with the introduction of the single currency.
What is being speculated about here is the emergence of another kind of risk premium, that related to government default.
Normally this would be unthinkable (although it did, of course, recently happen in Argentina). The rising deficits in some countries do, however mean it may come onto the agenda.
Japan is in the worst position, but of course Japan has many more resources to draw on than Italy does.
If the final version of the stability pact evolves in the direction of ‘every country fending for itself’, then Italy is a definite candidate for default at some stage IMHO.
Obviously default would only occur at the end of a fairly long road. The first stage would be an increase in the rate the Italian government pays to finance its debt (an increasing ‘spread’). This would not only make public finances worse (more tax income would be needed to service existing debt), but may well influence the amount Italian industry would have to pay to attract capital (this is still an unclear element). If this happened then you would have rising interest rates and a recession, a very unpleasant mixture (as Argentina discovered).
You are then effectively ‘hoisted on the petard’, and really only one of two things can happen:
* others come to your rescue
or
* you default
It’s much too early yet to speculate about how this would play out, but the issue is there.
“wouldn’t the federal government ultimately bail out, say, California if it was to default?”
Well, they were threatening not to, and in the rather more celebrated case of New York city in 1975 (which Doug sent me hurriedly away to Google about) there was a flat refusal to help.
My feeling is though a Metropolitan or even State default would be serious, but wouldn’t carry the same far-reaching implications as a default by an EU member state government.
The question isn’t really whether other member states would have a willingness to help, but rather, just how many would have sufficiently sound finances themselves to be in a position to.
Of course I am assuming continuing deterioration in the deficit problem more or less all round. I will hold to this till I see evidence to the contrary (rather than promises or one-off measures).
The recent deterioration in outlook for 2005 means we are unlikely to see next year’s targets met. And as for 2006, well let’s wait and see when we get a bit nearer.
Just to give an idea of the orders of magnitude involved here, it may be worth noting that since Italy currently has an accumlated deficit of around 100% of GDP, a 1% rise in interest rates would mean (on a rough and ready calculation) creating a hole in current spending of around 1% of GDP and so on. The numbers are large.
This is just one more reason why the Japanese government isn’t in any hurry to get away from zero interest rates (10 year bonds fluctuate between 1and 2%). With the accumulated debt at around 150% of GDP the impact on government spending of any significant raising of rates would be enormous.
This is also the issue that Paul Krugman is getting at in the US context, if the accumulating deficit forced interest rates up due the the Federal government’s need for funding.
Japanese bonds are, if i remember correctly, not exactly shortterm so i don’t see how a 1% in interest rates would immediately lead to a 1.5% rise in the deficit.
The problem is very real and can only be solved by transferring the deficit-spending function of governments in the EU to Brussels, possibly employing the kind of mixed state and federal financing that plays a large role in managing Germany?s government expenditures on the EU level as well. That transfer is just an inevitable consequence of the Euro project – otherwise the capital markets will indeed not go along and cause default crises (which will in due course give rise to those changes. There is not much of a likelihood that they will be enacted proactively.)
Of course, many will never get the point and claim instead that the problem is the debt itself. In a world of inconvertible currencies, public debt is identical with private wealth. You can?t have one without the other in our post-gold-standard economies, no matter what Bob Rubin may tell you. (Former FED governor Wayne Angell highlighted this fact in a WSJ editorial about the “Rubin recession” about a year ago.)
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