The spread between Greek government 10-year bonds and the equivalent German government securities rose sharply this week – Greek debt at this maturity now yields 6.0% vs. German debt at 3.1%. Other weaker eurozone countries appear to be on a similar trajectory (e.g., Irish 10 year government debt is yielding 5.8%) and if you don’t know who the PIIGS are, and why they are in trouble, you should find out.
We also know East-Central Europe (including Turkey) has major debt rollover problems and most of that region is in transit to the IMF, with exact arrival times determined by precise funding needs relative to the usual political desire to keep the party going through at least one more local election. Put the IMF down for another $100bn in loans over the next six months, and keep the G20 talking about providing the Fund with more resources.
But the big news of the week, with first-order implications for the US and the world, was from the UK where the prospect of further bank nationalization now looms.
This is a AAA-rated sovereign with its housing market in a nose dive, overextended (and apparently mismanaged) major banks, and a government on its way to guaranteeing all financial liabilities and directing the flow of credit moving forward. A strategy emerges, but it’s based more on depreciating the pound and surprising people with inflation than on fully-funded bank recapitalization. Additional fiscal stimulus, increasingly, looks at best irrelevant and – worryingly – perhaps even destabilizing. The yield on 10-year government bonds is, of course rising – now over 3.5%.
In this context and recognizing that credit ratings are a lagging but not meaningless indicator, Spain’s downgrade from AAA is a significant milestone. Further European downgrades are in the air.
What do all these situations have in common? We are repricing the risk (or coming to our senses) on the dangers of lending to a wide range of governments. And this is not just about emerging markets (East-Central Europe) or industrialized countries that sustained a boom based on euro convergence (the PIIGS), it is potentially about rethinking any government’s obligations.
What about German debt? There is no question that Germany will do whatever it takes to maintain a reputation for fiscal prudence. But problems in the eurozone put pressure on the European Central Bank to loosen its policies (and there are murmurs already about easing repo-rules as credit ratings fall; basically, supporting euro sovereigns during their downward spiral), and this has implications for currency risk. Also, German exports are under severe pressure – their cars, machinery, and similar durables, of course, have a great reputation, but how many of them do you really need to buy this quarter?
And what about the US? One view is that US government debt remains the ultimate safe haven, and this is surely true in general terms – particularly in moments of high stress. But I was struck recently by an excellent presentation by John Campbell (technical paper here). His point is that while US long bonds go through episodes when they are good hedges against prevalent risks (e.g., now and in the recent past), this is not always true. In particular, if inflation becomes an issue – think 1970s – then long bonds are really quite risky, in both popular and technical meanings of risk. You may think your bond holdings are a great hedge, but in fact they are a fairly substantial gamble that inflation will not jump upwards.
I also hear people increasingly talking about the limits on sustainable debt in the US (and we will shortly publish a Beginners’ Guide on this). I’m supportive of the fiscal stimulus, at around the currently proposed level, and I also strongly support the view that cleaning up the banking system properly will add further to our national debt (probably in the region of 10-20% of GDP, when all is said and done). And I further agree that some form of housing refinance program will help slow foreclosures, and this should further increase the chances that the financial system stabilizes.
But all of this adds up. US government debt held by the private sector will probably rise, as a percent of GDP, from around 41% to somewhere above 70%. This is still manageable, but it should concentrate our minds. The net effect of our financial fiasco is to push us towards European-style government debt levels, and this obviously presses us further to reform (i.e., spend less on) Social Security and Medicare. And we really need to make sure we don’t have another fiasco (of any kind) of similar magnitude any time in the near future.