Spain was back in the spotlight today, as rising bond yields suggested that investors remain unimpressed by the victory of the Popular Party in Sunday’s election. But the stress is spreading well beyond the euro area’s so-called periphery. Belgium, the Netherlands and Finland are also under pressure. Even in France, the 10-year bond yield differential versus Germany reached 200 basis points last week (Display
I think the contagion now spreading to the “core” of Europe stems from a key fault line in the euro area’s institutional framework that has been exposed by recent developments. When countries joined the euro, they knew that they were surrendering monetary sovereignty. They could no longer set interest rates to reflect and influence domestic economic conditions. And they gave up exchange-rate flexibility vis-à-vis their key trading partners. But that wasn’t all. Euro-area countries also relinquished control over the issue of their own sovereign currency. In essence, all euro-area countries now issue debt in a foreign currency—i.e., one over which they exercise no effective control.
This point is fundamental to understanding what’s going on today. One reason that investors are (relatively) happy to hold US and UK government debt, even though their fiscal positions are worse than many euro-area countries, is that investors know that both the US and UK can, in extremis, always produce the dollars or pounds needed to meet their obligations. The nominal value of an investment in US or UK government bonds is always “safe.” Even if the real value is eroded, investors can respond by demanding a higher risk-free rate. So there’s always a price at which investors will be willing to buy US and UK government bonds—especially as the exchange rate can also adjust downward.
Put another way, the US Federal Reserve and the Bank of England are lenders of last resort to their banking systems and to their governments. They can always print money to meet the government’s obligations. In the euro area, there is no lender of last resort for sovereign debt.
This might not matter in normal times, but it is crucial in times of deep financial stress. We’re now witnessing an old-fashioned bank run being played out among euro-area sovereigns. In this environment, the distinction between liquidity and solvency can quickly become blurred, as has been the case most recently for Italy.
To make things worse, monetary financing of the state is outlawed by treaty in the euro area, and it’s deeply controversial in some countries—especially Germany, where it evokes painful memories of prewar hyperinflation. This helps explain why the European Central Bank (ECB) is willing to act as a lender of last resort for euro-area banks but not for their sovereigns.
There’s no easy way out for the ECB. If it were to act as lender of last resort for sovereigns, the ECB would remove all pressure from governments to deal with a crisis that is largely of their own making, and which they can still resolve themselves—by accepting greater collective responsibility for legacy euro-area debt. But as the crisis starts to infect core countries, withholding support is becoming increasingly dangerous.
I think it’s only a matter of time before the ECB will step up its bond purchases, not as a solution to the crisis, but to bring the panic to an end and help restore confidence in solvent euro-area countries.