Saturday, November 26, 2011

Bond Vigilantes Are Attacking in Europe

They Are Real, They Are Just Not Here

Conservatives and other who have warned against having the U. S. engage in massive economic stimulus to get the stalled U. S. economy growing fast enough to reduce unemployment rates have pointed to what is now called “Bond Vigilantes” as the basis for their opposition to the large deficits that policy would create.  Their argument is that massive deficits would cause lenders who buy U.S. bonds to demand higher interest rates, and that the interest rate rises would harm the economy, thus defeating any gains expected from normal Keynesian growth policy.

The problem with this argument, as appealing as it may sound is that it just has not come true, at least not in the United States.  Contrary to expectation, interest rates in the  U. S. have fallen, not risen in large part because the U. S. economy has looked stronger than any European one, and because despite a reduction in its credit rating, government debt in the U. S. still looks like the safest investment out there.

The Bond Vigilantes Attack Europe

This is not the case in Europe.  The bond vigilantes have struck with force.  They have pushed up the yields on Italian and Spanish debt so high that the liquidity of these countries, that is the ability to borrow money to refinance debt coming due and to finance current budget deficits is in doubt.  Either or both of these nations may require massive bailouts.  And no, Europe does not currently have the resources to bailout both Spain and Italy.

Germany, the strongest European economy and the country so far that has escaped an attack by the bond vigilantes has just suffered it first attack.

Germany, which was seeking to raise as much as 6 billion euros, or $8.1 billion, in an auction of 10-year bonds, met demand for only 3.9 billion euros worth, leaving the state with twice as many leftovers as normal, the Bundesbank reported. The bonds, considered the safest government securities in the euro zone, were priced at an average yield of 1.98 percent, slightly above the prevailing market price.

Charles Diebel, head of market strategy at Lloyds Banking in London, described the auction flop as “a pretty significant buyers’ strike.”

No, there is no major concern about the German economy, at least not yet.  The concern is that Europe will not step up and do the right things.  European policy makers, led by Germany are making two huge mistakes.  The first is that they are demanding severe fiscal austerity in nations like Italy and Spain so that these countries can reduce their budget deficits.  They seem to have forgotten basic economics, that this policy will also reduce growth, reduce GDP and make the countries less rather than more able to meet their debt obligations.

The second problem is that Europe, again lead by Germany is refusing the let the European Central Bank be the lender of last resort.  To stem the panic in European bond markets the ECB has to say that it will support Italian, Spanish and other sovereign debts at a given level.  This is today the only policy that will stabilize bond markets and give Italy and Spain the time needed to reform their economies.  Germany does not want to do this because it feels such a policy will (1) reduce the pressure on those countries to reform and (2) lead to high inflation. 

The Germans may be right, but it doesn’t matter.  The current policy is doomed to failure; the alternative policy of empowering the ECP may well fail, but unlike the current policy it at least has a possibility of success.

All of those who have read the history of the 20th Century in Europe and want a weak, divided and economically devastated Europe raise your hands. 

 I don’t see any.

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