Between an economic rock and a political hard place
Civitas, 18 July 2011
One of the more interesting changes resulting from the financial crash and ensuing recession could be the way in which financiers seek to analyse future market movements: it could be a case of out with the economists and in with the politicians.
Nowhere is the effect which political decisions can have on markets more apparent than in the on-going tumult surrounding the Eurozone debt crisis. It has been emphasized this week that the Eurozone debt crisis is political, as well as economic. Perhaps adding to the volatility of the situation is the fact that it is becoming increasingly difficult to predict whether economic or political factors are having the larger effect, and that this distinction between them is false. Examining some of the issues and events of the current crisis reinforces this.
Take for example the question of whether or not Greece will default. For many commentators and market analysts a quick examination of the country’s current economic state signals only one thing: default. The current yield on a ten year Greek bond is 18.22, suggesting that the markets recognise this risk. The interesting thing is that bond yields rise and fall as political announcements are made. When bail-outs are agreed, not just for Greece but also other peripheral states (Portugal, Ireland), bond yields fall, when politicians appear unable to agree on a bail-out, yields rise. One doesn’t need an economist to help you decide how markets will move, a fly-on-the-wall at European Union and Eurozone meetings would be of far more use.
Greece however may be a bad example, its economic outlook is so dire that many feel that some form of default (euphemistically described as a ‘roll-over’, a ‘restructuring’ or a ‘reprofiling’) is inevitable. A far more opaque case is Italy. The crisis moved into worrying territory earlier this month when yields on 10-year Italian bonds rose to their highest since the Euro was created. What spurred such a move, was it politics or economics? The spat between Italian Prime Minister Silvio Berlusconi and his finance minister Giulio Tremonti was over the country’s austerity plans but reflected political considerations, such as whether austerity should begin to bite in this parliament or the next.
Moving from the particular to the general, the financial position of the Euro and the single currency project is itself determined by a curious mix of politics and economics. In many ways the Euro has been a political project from the outset, one which ignored the economic theory that argues a single currency is unstable, if not unworkable, when not supported by a system of fiscal transfers. How investors feel about the Euro will be shaped by political wrangling: will a closer fiscal union be swallowed by countries whose populations are adamantly opposed to it? Will Germany’s and Angela Merkel’s refusal to countenance the issuing of Eurobonds create a ‘two-speed Europe’ where the peripheral and Southern states flounder while Northern countries surge ahead? Or will the political will to save and extend the Eurozone, which has been apparent since its inception, prevail?
There is one final way in which the ensuing crisis blurs the lines between politics and economics and that is in the way in which market and state actors cannot be separated. This is most apparent in the false distinction, often made, between making private creditors pay and making tax payers foot the bill for any bail-out or debt restructuring. In many respects we are all on the hook because government’s have shown, most emphatically over the last three years, that where financial markets are concerned there is little appetite for ‘creative destruction’ and letting market forces dictate events. Letting private creditors take the hit would involve letting many European banks, pension funds and other large buyers of bonds witness a significant write-down of their assets, few governments would be willing to countenance this and we would probably see further financial assistance (e.g. tax payers cash) for affected European institutions.
The global economy and the global financial system are both still in a state of change, the more this change is marked by an increase in governmental intervention and regulation of the economy the more politics and economics will become intertwined. The result will be financial markets that have to interpret economic signals that have little to do with economics in the strictest sense, good luck to those tasked with predicting them.