The Greek Debt Crisis and the Attack of the Bond Vigilantes
As the past week's tumultuous and disconcerting events on Wall Street demonstrated, the fate of Greece is indeed relevant to not only the health of Europe's economy but also the U.S. economy, due to the financial ripples and shock waves that could result if policymakers fail to address the Greek situation correctly.
While one would like to hope that this weekend's decision by the European Commission to set up an emergency stabilization fund will be sufficient to stop Greece's sovereign debt crisis from spreading to other debt-plagued European nations, particularly Portugal and Spain, at this juncture it looks like even more action will be need. Specifically, central banks, led by the European Central Bank, will need to take monetary action.
The reason? It appears the global financial system is under siege from "the attack of the bond vigilantes."
First Lehman Brothers, Then Greece: Who's Next?
Economist Ed Yardeni, who now runs Yardeni Research of Great Neck, N.Y., coined the term "bond vigilante" in the 1980s to describe certain institutional investors who made a practice of shorting the bonds of governments when they saw unsustainable fiscal policies and other actions by governments or companies that they believed would lower the value of the bonds issued.
The decline and fall of financial giants Bear Stearns and Lehman Brothers, although without question rooted in their dubious, high-risk business practices and extremely overleveraged positions, were nonetheless accelerated by today's bond vigilantes. In the recent financial crisis, bond vigilantes shorted the now-infamous subprime mortgage-backed securities, many of which were vastly overvalued based on the false assumption that the subprime borrower category would have low default rates.
Now, the bond vigilantes are selling and shorting -- and in some cases, refusing to "roll over" -- investments in sovereign debt: the bonds issued by the debt-plagued governments of Greece, Portugal and Spain, among others. And that's weighing on investor confidence and roiling the markets.
European officials are hopeful their new emergency fund will be able to both stabilize Greece and stop the contagion -- in effect fight and check the bond vigilantes.
"We will defend the euro, whatever it takes," European Commission President Jose Barroso told members of the press Saturday after European Commission leaders met in Brussels.
But will the emergency fund be enough? The view from here argues that it probably won't be. The yield premium -- the extra interest rate that lenders are demanding to lend to Greece, Portugal and Spain -- is rising. On Friday, it hit 973 basis points above comparable German bonds for Greece, 254 and 173 basis points higher for Portugal and Spain, respectively. To paraphrase Los Angeles Dodger Manager Joe Torre, if contagion has disappeared, it's certainly doing a great imitation of still being around.
Should Weaker Economies Abandon the Euro?
Some say the key to stabilizing the Greek, Portuguese and Spanish economies -- the way to solve their debt crises and end the threat they represent to the euro -- is for those debt-plagued countries to remove themselves from the common currency. By resurrecting their old currencies, they could print more money and lower its relative value, thus increasing their competitiveness and giving them the ability to (at least partially) inflate their way out their huge debts.
The problem with the "leave the euro" solution is that it by no means is cost-free or ripple-free. Creating new, softer currencies that are by their very nature worth less than the euro implies that those banks and institutions that lent money to Greece, Portugal and Spain are probably going to paid back in currencies that are worth less -- thus decreasing the value of the investments. Lenders and investors want their money returned in hard currencies -- euros, dollars, pounds, Swiss francs or yen -- not in currencies worth slightly more than gum wrappers. Hence, any "leave the euro" plan would almost certainly send another shock wave through the world's stock and bond markets as they reacted to the likelihood of investments in those troubled countries losing value.
Others say the key to stabilizing Greece, Portugal and Spain is a bigger aid package, and that's my view as well. And Europe already has a blueprint for how to check contagion: the U.S. In autumn 2008, the U.S., thanks to the Bernanke/Paulson midnight Saturday you've-got-to-be-kidding TARP introduction meeting with congressional leaders, was able to pass the $700 billion Troubled Asset Relief Program. Was it popular? Hardly. Perfect? No way. But it ended the institutional failure trend and, along with the U.S. Federal Reserve's quantitative easing, returned liquidity to the credit markets. How big will Europe's version of TARP have to be? Probably just as big as the U.S. package was.
Speaking of quantitative easing, it looks like the European Central Bank will have to implement that as well. By law, the ECB can't buy government debt directly, but it can enter the secondary market to do so: It's sometimes referred to as the ECB's "nuclear option." The time has come for the ECB act. Even better, it should enlist the help of the Fed, the Bank of England, Swiss National Bank, the Bank of Japan, and if needed, other major central banks.
Last week's market sell-off gave the world a small taste of the negative consequences that could stem from an unwillingness by Europe's public officials to check the sovereign debt contagion. Contagion in Europe could seriously harm key financial institutions, which would result in them cutting back on credit for mortgages, auto financing, credit card lending, and loans to businesses, large and small. The credit crunch would slow Europe's economy, and probably tighten credit conditions in the U.S. as well. The U.S. would be hit with the one-two punch of a decline in commerce with a key trading partner and another cycle of constrained credit.
In other words, if policymakers don't act rapidly to stabilize Greece and prevent its problems from spreading, the world financial system could come under more Lehman failure-like stresses. The credit markets supply the lifeblood of the U.S. economy: if they contract now, at the very moment the economy is starting to gain some traction, it could seriously hurt the recovery or even tip the nation back into recession.
As one might sense, now is not the time for Americans to point fingers at Europe, the way Europe pointed fingers at the U.S. for its bad mortgage lending practices and credit card-financed consumption binge. Rather, now is the time for collective action by the world's major central banks and heads of government. The bond vigilantes are attacking like lions who have spotted a weak zebra and are maneuvering to separate him from the herd. Those lions aren't going to go away unless they're forced to do so.