Euro Zone on the Brink A Continent Stares into the Abyss
Part 2: A Buyers' Strike on Euro-Zone Debt
The more desperately the euro governments have tried to make the EFSF more effective, the faster the prices of euro-zone government bonds have fallen. "The term 'buyers' strike' isn't strong enough to describe what's happening," says Joachim Fels, chief economist at the American investment bank Morgan Stanley. "I would call it a flight from government bonds."
In November, the yields on Italian, Spanish and even French sovereign bonds shot up, mirroring the downward slide in bond prices -- a sign of the growing risk of default that investors now see on almost all euro-zone bonds. Recently, Italy had to pay interest rates of more than 7 percent on its 10-year bonds.
The question of how much longer the highly indebted peripheral countries can last is becoming more and more pressing. Close to 9 billion in Italian government bonds will mature this week, while more than 30 billion will come due by the end of the year.
When governments can no longer place their long-term debt with investors, they plug their holes with short-term loans. But investors are also demanding higher and higher yields for short-term bonds. On Friday, Italy had to offer rates of at least 6.5 percent for six-month bonds. By the first quarter of 2012 at the latest, when more than 112 billion in Italian bonds will mature, this short-term strategy will no longer work.
That's because an end to the buyers' strike is not in sight. In the first phase of the debt crisis, politicians from Berlin to Brussels still suspected that it was speculators, in conjunction with the rating agencies, who were driving Greece and others to the brink of insolvency.
It is now clear, however, that a broad retreat from the crisis-stricken countries is underway across almost all investor groups. "It's no longer just the banks. Now insurance companies, pension funds and even sovereign wealth funds are selling off euro-zone bonds," notes Joachim Fels, the Morgan Stanley economist. The fear of losses and of a breakup of the euro zone is driving investors away -- as are the politicians who have fueled this fear through poor decisions.
The first attempts to bail out Greece already planted the seed of subsequent failures. In May 2010, German Finance Minister Wolfgang Schäuble wrested the promise -- albeit a nonbinding one -- from German banks that they would keep their credit lines to Greek banks open and would not sell off the country's bonds.
A year later, the banks felt betrayed. After weeks of negotiations, the banking industry grudgingly agreed to a "voluntary" haircut on Greek debt. Initially, the banks abandoned 21 percent of their claims against Greece, and in October they agreed to accept a 50-percent writedown on their Greek holdings.
Investors see the involvement of private creditors in the debt-relief program as a serious blunder. If one country in the euro zone isn't able to fully repay its debts, who can guarantee that it won't be joined by another country in the future?
Josef Ackermann, the CEO of Deutsche Bank, warns that there are many investors in the United States and Asia who will no longer want to invest in euro-zone bonds under these conditions. "We will be paying a high price for a long time to come for having violated the principle that European government bonds are risk-free," he recently said in Frankfurt.
Many others in the banking industry agree. On the sidelines of the November 2010 G-20 summit in Seoul, the euro-zone countries signaled that the participation of private investors in the costs of a national bankruptcy would only be possible on new debt issued after 2013, at the earliest. In the nervous fall of 2011, investors have now realized that these assurances are worthless.
Politicians have also made other mistakes. On Oct. 26, the euro rescuers in Brussels, Paris and Berlin imposed higher capital reserve requirements on their banks, so that they could brace themselves against possible defaults on euro-zone government bonds. The lenders now have until Christmas to explain how they intend to meet the new standards by the end of June 2012.
But what was intended to stabilize the euro-zone banking system and mitigate the consequences of a possible national bankruptcy came back like a boomerang. First, with their decision, the euro partners signaled that they themselves were anticipating defaults. In that situation, any rational investor would try to sell off their euro-zone holdings.
Secondly, most banks are not trying to raise new money to reach the new equity capital requirement of 9 percent of total assets. This wouldn't even be possible, given the hyper-nervous markets. Instead, the banks are reducing the size of their balance sheets, and thus their capital requirements, by selling off assets -- such as government bonds.
According to a study by the Landesbank Baden-Württemberg (LBBW), a German state-owned bank, the banks in the core euro-zone countries have reduced their holdings of government, bank and company securities from the EU periphery by 25 percent, down to 1 trillion, since the beginning of 2010. "The trend (toward reduction) is likely to continue," the LBBW concludes.
What is more, bank regulators are making government bonds fundamentally less attractive to banks in the future. Until now, banks were not required to secure investments in European government bonds with capital. This was advantageous for the governments, because it meant that they would always find willing buyers for their debt among banks. This will, however, probably change under new regulations for banks, which will also require them to maintain capital reserves to back investments in sovereign debt.
The calendar is also accelerating the flight from government bonds. Banks, investment funds and insurance companies close their books shortly before the end of the year and make hardly any new investments. At the same time, they often sell off those securities that have brought them losses, like European government bonds. Few institutions would want to have to explain to investors why, after a debt crisis that has lasted almost two years, they are still sitting on the sovereign debt of crisis-ridden countries.
For all of these reasons, the debt-stricken nations are now cut off from access to new money, just as banks were after the Lehman Brothers' bankruptcy of 2008. Who will finance them in the future?
The Last Hope
The meager successes of the euro rescuers to date have fueled calls for the use of what is perceived as a stronger weapon: the ECB's so-called "big bazooka." Until now, the Germans, in particular, have refused to deploy the central bank's ultimate instrument of deterrent, but the pressure is mounting.
In recent days and weeks, world leaders including US President Barack Obama, British Prime Minister David Cameron and Spanish Prime Minister-elect Mariano Rajoy have called upon the new ECB President Mario Draghi to embark on permanent and unlimited purchases of the bonds of troubled euro-zone nations in future, using what is in principle the infinite capacity of the money presses. This would, in a manner of speaking, turn the ECB into Europe's lender of last resort. Economists and politicians want to see Europe's monetary watchdogs rush to the aid of its governments, using the US central bank, the Federal Reserve, as their model.
But the ECB has already been buying sovereign debt for the last year and a half. The central bank has now spent more than 190 billion on Greek, Portuguese and Spanish bonds, but the results have been less than encouraging. Despite the ECB's increasing intervention, risk premiums are still going up. Axel Weber, the former head of Germany's central bank, the Bundesbank, and Jürgen Stark, the former chief economist at the ECB, resigned in protest against the questionable measures.
Weber and Stark were convinced that the controversial purchases not only violate the traditional principles of the Bundesbank, but are also illegal in the long term. Weber's successor, Jens Weidmann, agrees, and he vehemently opposes all attempts to fight the euro crisis by printing money.
Opening the Floodgates
The ECB's interventions are still somewhat justifiable, because they are limited in scope and in time. However, if the central bank were to open all the floodgates, as some are demanding, its actions would hardly be compatible with the European treaties. They expressly prohibit the ECB from financing the countries of the euro zone with the money presses. The Treaty on the Functioning of the European Union states that the central bank may not "purchase (debt instruments) directly."
The ECB is only permitted to buy government bonds on the so-called secondary market, i.e. indirectly from investors like banks and insurance companies, but not on the primary market, or directly from the issuing countries. But what happens if investors don't buy the large numbers of bonds that will come on the market in the coming weeks and months? Then the bazooka will only work if the ECB buys the debt securities directly.
In fact, say market players, the ECB is already circumventing the prohibition on direct government financing today. They argue that countries like Italy and Spain were only able to raise sufficient new funds at 7 percent interest because the ECB took securities off the market before and after their auctions.
Investors and governments are calling on the central bank with increasing urgency to buy the sovereign debt of cash-strapped countries on the primary market as well, and in much bigger amounts.
The Fed as Example
There are many who see this further breach of the European treaties as the lesser evil. They argue that Europe is in an extraordinary state of emergency, because if nothing is done the monetary union will collapse, plunging Europe into crisis.
Many advocates of increased ECB interventions point to the American Fed as a model. However, the Fed buys US treasury bonds primarily to flood the domestic economy with money. The purchases are not needed to finance government spending, because the worldwide demand for US bonds remains consistently high, despite the country's high debt levels.
It's a completely different story in Europe. If the ECB were to issue the desired general guarantee for all government bonds, it would reduce itself to acting as the servant of the European debtor nations. Its political independence, one of the most important principles on which the monetary union is founded, would be lost.
German taxpayers, in particular, would be left to suffer the consequences. As soon as a country became unable to repay its debts, the ECB would be forced to write off the bonds, and German taxpayers would be burdened with more than a quarter of the losses. Thus, in a roundabout way, the ECB would become the facilitator of precisely the "transfer union" that the German government is determined to avoid.
What's Wrong with a Little Inflation?
This too is one of the distinctions between the European and US central bank systems, says the Oxford-based German economist Clemens Fuest. Unlike the Fed, the ECB is responsible for a number of different countries. According to Fuest, if it were to buy up the bonds of certain countries, the risks would be redistributed within the European central bank system. "The Americans don't have this problem," says Fuest. "That makes it easier for them to intervene."
Critics fear that unlimited sovereign debt purchases will fuel inflation. Europe's monetary watchdogs are trying to neutralize the purchase of Spain or Italy bonds by requiring that the banks, in return, invest their money in forward accounts with the central bank. But many economists warn that with this method the ECB could only keep the money supply constant for a limited period of time.
"At the latest when the demand for credit in the private economy picks up again," says Bonn money expert Manfred Neumann, "the banks will dissolve the forward accounts and channel the funds into the economy," thereby triggering inflation.
The question is whether this would be such a bad thing. Isn't a little inflation an acceptable price to pay for saving the euro? What are the relatively minor losses for savers and asset owners compared to the costs of a collapse of the euro?
The question is more difficult to answer than it would seem at first glance. Economic history teaches us that once inflation is underway, it is often difficult to control. To make matters worse, if governments hope to sell their bonds in times of rising prices, they must offer buyers higher yields. The debt burden grows and, with it, the financing risk for government budgets.
Thus, it cannot be ruled out that the ECB interventions that are being called for will ultimately produce completely different results than expected. The risk of government bankruptcies would actually be increased instead of being reduced -- across the entire euro zone.