Read the right headlines, and you could be tricked into thinking that there has been substantive progress recently regarding the debt crisis. But don’t be fooled — there are very unhappy politicians and very unhappy bond traders who have a different opinion on the matter.
For starters, there’s very little chance of full integration in whatever “fiscal union” is created for the euro zone. Germany never will agree to let its government spending hinge on approval from member states, and it never will be able to stomach bankrolling spendthrift debtor nations like Italy. Similarly, smaller players in Europe won’t take lightly to receiving marching orders from Germany.
Yes, the reality is that we are rapidly approaching a stage where the only options are for euro zone nations to get much cozier with each other or to break up completely.
Signs of contagion have been crystal clear in the last week or so as Belgium suffered a downgrade from Standard & Poor’s just days ago and was forced to pay a yield of over 5.6% for 10-year bonds — its highest rate in more than 10 years. Much-maligned Italy fared even worse, at a 7.2% rate. Something has to be done.
But even if politicians can forge a grand deal that appeases disparate parties — fiscally responsible nations Finland and Luxembourg, for instance, spoke out rather absurdly this week in protest to proposed treaty changes that would expedite any mandates for fiscal discipline — let’s not forget that bond investors are really the ones with all the power here.
A recent piece in The New York Times by Alan Cowell notes that “In Greece and Italy, as in Ireland and Portugal before them, unelected bond traders defined the destiny of elected leaders.” Cowell was, of course, talking about how Italian Prime Minister Silvo Berlusconi and Greece Prime Minister George Papandreou were forced to resign as their respective nations faced an utter inability to borrow money.
The simple fact of the matter is that governments raise money in two ways: from taxes, and by borrowing from the global bond market. Since the most troubled euro zone nations cannot possibly survive on tax revenue alone, the only solution is borrowing — no matter how steep the interest.
That’s where things start to get really ugly. Some estimate that Italy is the third largest issuer of debt in the world. What’s more, reports indicate that for every additional percent of interest, Italy has to pay roughly 3 billion euros more in debt service — or roughly $4 billion U.S. That added burden means Italy will need to float more bonds to meet its obligations, adding to uncertainty about whether the country can repay its debt. Uncertainty raises rates on those bonds which raises the amount of debt service they demand — and the cycle repeats itself.
There are reasons to be optimistic that the European Union will find a viable solution to its debt crisis and forge a strategic alliance in time to prevent further contagion. Intervention from the European Central Bank and International Monetary Fund will help. And let’s not forget that it is in everyone’s interest for the euro zone to stay viable — from member states to investors to strategic trade partners.
But there remains a very real chance that the dominoes will continue to fall as interest rates soar higher and investors demand high premiums for any loans to euro zone nations.
If you need further proof of how uncertain things are in Europe, consider this: Even as Fitch has warned another credit downgrade could be in store for the U.S. and even after the congressional supercommittee failed utterly to reach a much-needed compromise on spending cuts, 10-year T-Notes are once again yielding less than 2% based on Monday’s close of the bond markets.
If America is that “safe” in this environment, it tells you everything you need to know about how risky most people think Europe is right now.