We have three observations to make on the latest shenanigans to hit the Eurozone.
Firstly, default of some sort seems inevitable. Secondly, it seems that in a funny kind of way, Angela Merkel and arch-Keynesian Paul Krugman agree. Both seem to think that markets need to be encouraged to throw their money at business, and stop wasting it on buying assets they think are safe but in the process do little for the economy, which in turn makes these assets far from safe. And finally, we are concerned about interest rates.
First of all, it really does seem hard to believe that we can avoid some kind of sovereign default and either an exit from the euro, or maybe even the emergence of two euro currencies. Countries such as Ireland, Portugal, Spain and Greece have seen such a loss in competitiveness over the last few years, that it would take very severe wage deflation to put that right. But as wages fall, house prices will look even more expensive, household debt relative to income will surge (this is especially a problem in Ireland, Portugal and Spain, less so in Belgium and Greece), and as wages fall, demand will fall, leading to slower growth, less tax receipts, and maybe as a result debt will get worse.
For more on Belgium’s problems click here: Is Belgium like Greece, or Germany?
Secondly, in an odd kind of way Ms Merkel and arch-Keynesian Paul Krugman are saying something similar. Nobel Laureate Krugman is a fan of governments spending more to get us out of crisis. So on the surface, his views and Ms Merkel’s are polar opposites.
But what Mr Krugman has said, on numerous occasions, is that if investors stopped buying government bonds, and threw their money at business, GDP would rise and government borrowing would fall. So, he is suggesting that while a flight from bonds would be bad news for governments trying to raise money, such a development would be good for the economy as a whole, and that in any case, under these cicumstances, governments would not need to borrow so much.
He is right, although whether he is right to conclude that the solution, then, is for governments to borrow more, is another matter.
Ms Merkel, on the other hand, wants to punish bond investors for pouring their money into the wrong assets.
The real error the markets made was to see house prices, and more recently bonds, as low risk, and investment into innovation and enterprise as high risk. Initially their error led to a housing boom, which as we all know ended in tears. Now it has created a boom in bond prices.
But growth depends on creating new products, and services that serve consumers. And markets seem to be allergic to providing money to businesses that do this. And until they do, the economy will limp forward.
And if markets are going to get bailed out every time their strategy becomes unstuck, they aren’t going to change their strategy.
The third point is a more philosophical one.
If markets are forced to take losses, the long-term consequence will be higher interest rates.
It is easy to forget that we live in an age of absurdly low interest rates. It’s these low rates which are keeping debt affordable. The yield on Irish ten-year bonds moved over 9 per cent this week. Yields on Spanish bonds rose over 5 per cent. On the BBC business news this morning, the one that is broadcast at 5.30, one of the presenters talked about yields hitting an all-time high. Then she realised what she said and corrected herself. Yields are not that high at all, they are just at post-recession highs.
We are panicking about the prospect of interest rates returning to levels that were once considered normal.
The truth is, the global economy is incredibly vulnerable. If rates return to anything like the levels we once thought were quite good, then a new debt crisis will emerge. And yet even at low rates it seems some debts are close to default anyway. Such a default will push interest rates up, more loans will be written off, and the queue at the economic hairdressers, full of bond investors accepting losses, will be inversely proportional to the queue at the real-world hairdressers, where a new age of frugality may see us opt for the kind of hairdos the Normans had. (That’s a bowl over our head, with the barber cutting around the outside.)
Default is the inevitable consequence of the mistakes that were made in the past, when investment in assets that did nothing was seen as less risky than investment in business.
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