By the time you read this article, Greece may or may not still be in the Eurozone. But whether Greece is in or out, the European sovereign debt crisis will almost certainly still be raging on. The focus of investor worry has, in any event, moved westward to Spain. The Spanish 10-year bond yield hit 6.5% on Monday, and the spread between Spanish and German yields hit a euro-era record.
While there are no quick fixes, one of the options on the table is the issuance of Eurobonds. The precise mechanics of how an issuance would work remain unresolved, but the basics are simple: the 17 member states of the Eurozone would issue bonds collectively and accept joint liability for the outstanding debt.
Before you draw the wrong conclusions, this is not at all similar to the United States federal government issuing Treasury securities. In that case, the U.S. federal government raises funds for its own operations, not the operations of the 50 U.S. states. Imagine instead the 50 U.S. states borrowing collectively and distributing the funds amongst themselves, and you can quickly see why the proposal is controversial. Texas, a low-tax, small-government state would not be particularly fond of effectively guaranteeing the debts of, say, big-spending, high-safety-net California. Likewise, German or Dutch citizens would resent lending their own country’s credit rating to less-disciplined problem countries like Spain or Italy. And in the case of Germany specifically, such a move would likely be unconstitutional.
Suffice it to say, the issuance of Eurobonds would be one of the more difficult solutions to implement, but the idea is not without its merits.
For smaller, non-crisis countries, such as Austria or Luxembourg, the increased liquidity of a Eurobond relative to their current, relatively illiquid domestic markets would mean lower yields and borrowing costs.
And for crisis-wrecked countries like Spain or Italy, their bonds would effectively enjoy Germany’s rating, and yields would be more than halved overnight. Such a move would make their debts payable and take away the immediate threat of meltdown.
Unfortunately, there is that pesky little critter known as “moral hazard” that presents a challenge. Germany wants to keep the pressure on the Eurozone’s problem children in the hopes that the fear of meltdown will force them to implement needed economic reforms. And they rightly fear that bailing out the periphery countries too soon will breed complacency and that the reforms will simply never happen. Essentially, they want to avoid creating another Greece.
For these reasons, a Eurobond scheme would have to have some kind of enforcement mechanism to ensure that the problem states kept their budgets under control. But this would also mean some kind of new treaty, because nothing in the European Union’s assorted arrangements or institutions allows for anything strict enough to make the plan workable.
Whatever Europe’s leaders decide to do, they had better do it quickly. Their indecision has consequences.
Virtually everyone practicing the investment management profession today was taught in business school that markets efficiently process information and reflect that information in market prices. Prices reflect the underlying reality. Therefore, rising bond yields reflect investor fears about the creditworthiness of the borrowers in question.
The problem, as George Soros explained in his Theory of Reflexivity, is that the tail also wags the dog. Prices not only reflect the underlying reality; they affect it as well. Rising yields have a way of creating a self-fulfilling prophecy; investors, by pushing yields to unsustainable levels, effectively create the event that they feared most by pushing the borrower into default.
At time of writing, I do not believe that Spain or Italy is at risk of default, and in fact I have several open positions in Spanish stocks (see “Bargain Hunting in Spain“). But part of my bullishness is predicated on my belief that the European Central Bank will act aggressively to force down yields to more sustainable levels. I also expect Germany to take a more relaxed stance when presented with the truly awful alternative of a Eurozone meltdown.
We shall see. But until something close to an agreement is made, expect the volatility of recent months to continue.