Bond Markets Ain’t All Bad

The bond markets have caused havoc in Europe.  A rapid surge in interest rates on the debt of some European countries have forced governments to cut back on spending at a time when economic theory would argue for governments to spend more.  The results have been carnage.  There have been riots in Greece, protests in Spain, and the toppling of numerous governments in Europe.  Many people have pointed a finger at the bond market implying some notion of culpability for this.  The bond markets have something to answer for but not for the current situation.  To understand why, we must first however look at the role of the bond market in setting interest rates on debt.

Interest rates on bonds are set by the forces of demand and supply.  A large number of buyers will increase the price of a bond which will result in a lower interest rate.  This is a concept that even I struggled to come to terms with so I will provide a theoretical example to explain why bond prices and interest rates move in opposite directions.

For example, consider a government selling a fixed number of bonds where buyers pay $100 now and receive $150 in one year which is a return of 50%.  The high return attracts other investors who buy the bonds from the original buyers at a higher price and the price increases to $120 but the amount which is paid out at the end of the one year is still $150 so the return on the bond is now $150/$120 = 25%.  The government can now sell more bonds at the lower interest rate. 

But the opposite can also occur.  If investors do not think that the government can pay back $150, the original return of 50% will be seen as too low in relation to the risk that the government will default.  That means that if the original buyers want to sell, other investors will want a higher return to compensate for the riskiness of the bond and so the price of the bond will fall.  For example, investors may only offer to buy the bonds for $75 which means the interest rate on the bond is 100% (i.e. investors will double their money).  And if the government wants to sell more bonds, it will have to pay the higher interest rate.

The changes in the interest rates in this manner are an important part of the essential role of the bond markets.  In theory, the return on any investment must be enough to reward the investor for taking the risk of investing their money.  So interest rates provide an important signal on the risk that the government or the company that has issued the debt will not be able to pay back the money.  It also acts as a warning to governments that take on too much debt (or any other action that would be seen to hamper debt repayment) that they will be punished by higher interest rates.

So the problem is not the high interest rates that some governments in Europe are currently been forced to pay but that there was no warning from the bond market prior to the crisis.  Previously, investors had been happy with the same interest rates on all bonds from countries using the euro whether it was debt from Germany or Greece.  So Greece and the other counties have no notion that they would fall out of favour so quickly once investors realised that some government may struggle to pay their debt with the economic conditions having rapidly deteriorated.

Previously, the bond markets had been feared by any government who dared to spend too much.  One advisor for Bill Clinton was famously quoted as saying that if reincarnated, he would “want to come back as the bond market. You can intimidate everybody”.  But in the lead up to the recent financial crisis, bond investors had been caught napping.  The investors would have lost money as the prices of bonds of Greece and the other plunged but it is the citizens of Greece and elsewhere who pay the heavier price.

Another Bailout for Greece but More Likely to Follow

Greece was bailed out again last week, and despite a lot of people losing a lot of money, Greece will probably need further funds down the line.  Let’s have a look at why this is likely to be the case (despite what politicians in Europe would have you believe).

First, why a second bailout and why now?  Discussions with the Greek government about how to deal with its high level of debt had been dragging on.  Politicians in Greece were understandably keen to reduce the burden on its citizens who had to suffer amid the slump in the domestic economy.  However, the proponents of the bailout, the European Union (EU), the European Central Bank (ECB), and the International Monetary Fund (IMF), wanted to impose requirements for the Greek government to slash government spending to deal with the mountain of debt despite the pain this would cause.  The negotiations could have continued except for that Greece had to repay 14.5 billion euros worth of debt in March but didn’t have the funds. 

The bailout itself is to deal with the sheer size of the debt taken out by the Greek government.  The outstanding amount of Greek debt was around 165% of the GDP of Greece in 2011.  It is not only the scale of the bonds but also the lack of growth in the Greek economy.  This is important for paying back the debt as a larger economy will result in higher tax revenue for the government to reduce the debt.  However, the Greek economy shrank around 6.0% in 2011 and is expected to be 3.0% smaller in 2012 with growth forecast to return only in 2014.  The economy in Greece may struggle to even achieve these dismal estimates as the cuts to government spending could create a vicious cycle where cuts to spending weaken the economy and result in lower tax revenues which, in turn, increase the size of the necessary spending reductions. 

The rescue plan for Greece is expected to cost 130 billion euros with private bond holders “voluntarily” accepting a 53.5% reduction in the value of the bonds.  The actual losses for investors in Greek debt is more than this as the deal also involved a reduction in the interest rates on the Greek debt.   The lower rates mean that investors will be getting less money than they thought and the value of the debt will in fact be reduced by 75%. 

Despite all this, the aim of the bailout is merely to reduce the amount of Greek debt to 120% of GDP by 2020.  That is the same relative level as Italy is at now and is a relative amount of debt which is still seen as problematic.  So the bailout is not going to solve the problem of high debt.  And these plans rely on growth predictions and assumptions about privatization in Greece that many believe are “optimistic” to put it politely.  But, everyone from politicians in Greece and Europe and investors were adamant in avoiding a messy default where holders of Greek debt could lose even more and the market for government debt in Europe would have been thrown into disarray.   

So, this all points to the likelihood that Greece won’t be leaving the front pages of our newspapers any time soon.

Economists save world (for now)

A slight exaggeration maybe but economists at central banks in different countries have been decisive in dealing with the global financial crisis while politicians have been bickering about different ways of dealing with the problems.

Conventionally, lowering of interest rates is the main tool for central bankers to combat weakness in the economy but a new set of tools was deemed necessary after interest rates of close to zero have proven to be inefficient in combating the current economic downturn. Central banks now rely on quantitative easing which is the purchasing of government or other bonds using money which the central banks can print themselves as a way of increasing the money supply. In theory, an increase in the money supply means that there is more money for consumers to spend which is a boost to the economy but may also cause inflation (which is not a problem at the moment).

While the Federal Reserve and the Bank of England have each carried out a couple of rounds of quantitative easing, perhaps the prize for the most ingenious and effective policies in the face of adversity goes to the European Central Bank (ECB) and its new governor Mario Draghi. Central banks are usually set up independently from the governments in each area but governments can still wield a degree of influence over the operations of the central banks. This has been particularly true in the case of the ECB.

While central banks in the US and UK have purchased bonds issued by their government in order to reduce the interest rates on government debt, the ECB has been prevented from doing this by politicians in Europe. Many countries in Europe lead by the Germans are against the ECB purchasing the government bonds of countries in Europe with high levels of government debt such as Greece, Italy, Spain, or Portugal. The resulting lower interest rates on government debt would help relieve the pressure on these countries but Germany would rather that the higher interest rates spur the indebted countries to changes their ways.

The ECB has come up with a way of prompting purchasing of the government bonds of European countries without actually doing the buying itself. Draghi, the new governor, expanded the lending by the ECB to banks in Europe to allow for borrowing at its main interest rate (currently 1.0%) for up to three years. This meant that banks could borrow funds cheaply off the central bank and make easy money by buying government bonds which offered considerably higher returns. The ECB provided 489 billion euros of loans to banks in December and this had the effect of lowering the interest rates on bonds of European countries which have made earnest efforts to reduce government debt while keeping the pressure on other countries which have not.

Funnelling money through the private banks has proved a clever way of realising the policy of quantitative easing in the case of the ECB which has the choice of many different government bonds to buy. By providing private banks with the funds to purchase government bonds, it has meant that which bonds to buy is left in the hands of investors which allows for rational decision making based on market principles rather than being influenced by politics.

So the ECB was ingenious enough to come up with a way of easing the crisis in Europe despite obtrusive politicians. Not exactly saving the world but helping out under difficult circumstances.

Stocks Up Despite Doom and Gloom

After all the doom and gloom in my last posting, I noticed a strange headline in the newspaper. The negative outlook for 2012 would suggest that stock prices would not be doing so well, but instead, stocks are the highest they have been since the plunge in the markets amid the financial crisis. So while economists typically like to stay clear of talking about stocks, hopefully I can provide some insight into what seems to be a bit of an anomaly.

Stock prices often move in directions that are different to what is actually happening in the economy. One explanation is that investors will purchase stocks not only based on what has occurred in the past but also what is predicted to happen in the future. This means that the stock market is dominated by whether investors are feeling optimistic about the future or are downbeat on the prospects for companies making profits. The forward-looking nature of investors means that stock prices are typically seen as a leading indicator – a measure that points to an upturn or downturn in the economy before this is registered in the actual growth data. This may be the case here but it is unlikely considering, for example, the Federal Reserve in the US is planning to keep interest rates at close to zero as mentioned in the previous posting.

Instead, market sentiment has been buoyed by the outlook for interest rates that was released recently by the Federal Reserve. Weak prospects for growth in the US economy have prompted the central bank to state that it expects to hold interest rates down until late 2104. This implies a negative outlook for the economy but it is taken as being positive for stocks. The reason for this is because low interest rates mean that the return from bonds will typically be low and investors who are looking for a better return will be tempted to invest money in stocks instead. Stocks in the US have already bounced back strongly after a massive sell off when the Dow Jones Industrial Average plunged from around 14,000 in October 2007 to below 7,000 in March 2009. The Dow Jones index has since climbed back up to near 13,000 by the beginning of February 2011 which is the highest since May 2008.

The stance taken by the Federal Reserve is positive for stocks in other ways. Consumers and firms will be more likely to borrow if interest rates are low. Also, the commitment to keep interest rates low further suggests that the central bankers in the US will take less aggressive policies against inflation and this is a positive sign for some companies. Higher inflation means that firms such as electricity and gas providers as well as other companies which sell energy products would have more scope to increase prices and this would help boost profits.

Of course, this is not the only reason for the recent gains in the stock market. Data out last week showed that employment is on the rise with 243,000 jobs created in January in the non-farm sector. But the central bank’s policy does provide a background whereby the attractiveness of stocks is increased compared to other investments which means more money will flow into stocks along with any improvements in the economy.

Not any great investment advice, but hopefully, the world may make a little bit more sense.

A New Year but Nothing to Celebrate

The New Year is typically a time for celebration and a chance for many to start anew, but for the global economy, things look set to get worse in 2012 and the light at the end of the tunnel still seems a long way off.  A slew of news items this week has highlighted this trend.

The International Monetary Fund (IMF) has lowered its forecast for global growth for 2012 to 3.3% compared to the 4.0% expansion which was predicted four months ago.  More significantly, the new estimate for growth is less than the 3.8% for 2011 which means that things are going to get worse for many countries.  Top of the list of those expected to have little to look forward to in the New Year is Europe.  The IMF expects a 0.5% decline for the Euro area in 2012 with Italy and Spain predicted to suffer falls in GDP of 2.2% and 1.7% respectively.  Things are even set to take a turn for the worse in Germany which grew 3.0% in 2011 but it only expected to eke out growth of 0.3% in 2012.

While certain circumstances in Europe, such as the turmoil surround government debt, are specific to the region, other drags on the economy such as cuts to government spending, high unemployment, and a lack of confidence are much the same elsewhere.  Figures out this week for the UK showed that the economy shrank by 0.2% in the last three months of 2011 with unemployment at a 17 year high.  The dip in GDP means that the UK could suffer a double-dip recession – a recession being technically defined as two three-month periods of negative growth with the double-dip referring to the economy being unable to build up sufficient momentum to recover from an initial recession and slipping back in a recession. 

But perhaps the most depressing of news this week came from the Federal Reserve in the US who announced that it does not expect to raise interest rates until late 2014.  This is good news for those borrowing money but for everyone else it is a signal that the US economy is not expected to register strong growth any time soon.  It is also a sign of the desperation of central bankers who dislike publishing forecasts for interest rates and in so virtually committing to a target range of 0% to 0.25%.

Central banks everywhere are having to come up with novel ways of trying to boost the economy through monetary policy (the setting of interest rates or the money supply) as other options using fiscal policy (increased government spending or lower taxes) are limited due to high government debt.  But central banks only have a limited arsenal and a promise to keep interest rates their current record low levels is one way to convince consumers and businesses to borrow but considering the lack of punch that the interest rate policy has had so far, central bankers will be setting much of 2012 and beyond coming up with new ideas on how to start providing us with better news.

The Politics behind the Euro…

In trying to understand the reasons behind the eurozone crisis, economics can explain a lot of things (see posting below) but sometimes it doesn’t provide all of the answers.  Economics does give us an understanding of what happened over the past 10 years or so in regard to the building-up of imbalances and the actual turmoil that these caused.  But it does not give us reasons why there was a system which allowed the imbalances to occur in the first place. 

The economic problems partly stem from that the currency union of the euro has always been more of a political project than being backed up by compelling economic reasoning.  After the Second World War, the integration of countries in Europe was seen as a means to control the rise of excessive nationalism that had culminated in two world wars.  Various treaties were signed and groupings of European countries were formed up to the founding of the current European Union in 1993 and the euro was launched in 2002.  In this manner, the euro can be seen as a part of a process of European integration that had been going on for over fifty years before the euro itself came into existence.

This does not mean that there are no economic benefits from the euro as the previous post shows.  Some of the gains from having a single currency in terms of the ease of doing business or just travelling within the Europe as well as creating the large market to rival the U.S. would have given further impetus to the creation of the Euro.  However, politicians in Europe have always seemingly believed in greater integration for lofty ideals.  It was this focus on the politics and not the economics of the euro that blinded the countries involved to the potential pitfalls.

The difference between the ideals and the reality was further reinforced by the fact that the development of the European Union was very much a top-down system.  Politicians would dream up ways of bringing their countries closer together while voters in these countries didn’t seem care enough either way to put a stop to it.  As such, the citizens were never convinced of the necessity behind the growing level of integration nor did they have much of a role in pushing it forward.  Politicians could continue with this process as long as times where good.  And times were very good, too good, for some of the newer members who benefited from lower interest rates after having joined the euro.

But the mix of voter indifference and benign economic conditions may have meant the politicians pushed integration further and deeper than their citizens or their economies could manage.  Voters in Europe had shown signs before the crisis that they were not happy with the ever expanding European Union such as protests over immigration and referendum results against a new constitution for Europe.  Construction booms in Spain, Ireland, and elsewhere should have suggested that the interest rates for the euro were too low for these countries and highlighted the perils of applying the same monetary policy to different economies across the eurozone.

But it was the financial crisis that bought these issues to the fore.  And now it is the economic consequences that dominate, and voters are not happy with the mess that their politicians have allowed to occur.  Germany is not ready to make their tax payers foot the bill for the perceived prolificacy of others in the eurozone while Greece who joined for the economic benefits are not willing to toe the line and take the painful measures for the sake of the European project.  And it is renewed emphasis on economic concerns that is making the search for a solution more difficult, but that will have to wait for another positing.

… and the Economic Realities of the Euro

The eurozone had mostly been about the politics of integrating Europe.  But not anymore.  The economic consequences of the euro have come back to bite and now threatens the whole European project.

Back in the good old days, there was some economic rationale between the shared currency.  It helped to build a common market among the European countries by making it easier for businesses to operate in different countries (although different regulations in each country do hamper this).  The euro is also more stable as a currency compared to the currencies of many of the smaller members of the euro which helps to lower borrowing costs.  These benefits have been used as a carrot to get countries to reform their economies and improve their public finances (crucially, the tough rules for applicants to the euro do not apply to those countries who already use the euro).

However, on the flipside of these benefits is that in terms of the exchange rate of the euro and in terms of monetary policy (i.e. interest rates), it is necessary to adopt a policy of one size fits all.  So instead of each country having a currency which changes depending on their own specific circumstances or interest rates which could be set as each country saw fit, one exchange rate and one interest rate is applied across countries with very difficult economic conditions. 

A lower interest rate for new members is one key result of this.  The reason for this is there are risks involved in lending in a currency which is different to your own and especially when the exchange rate of the currency can change significantly or when lending to a country who can manipulate its own currency (both are usually true for members new to the euro).  Also, poorer countries typically have higher interest rates as there are less funds that are available for lending and because investments in developing countries are typically more risky.  And, for a long time (but not anymore), investors did not differentiate between the government bonds from the different countries in the eurozone.

So when a country (which is typically poorer) joins, it has a new interest rate that is typically too low for its economy but is set for the average conditions across the eurozone (a group of rich countries with low inflation rates).  The low interest rates fuel a surge in borrowing and these funds tend to be used to buy property among other things.  A booming real estate market triggers a rush to put up more buildings which also boosts the tax revenue for the government.  But this lending spree can easily get out of hand and has to end sometime and often painfully (as can be seen in the papers with regard to Greece, Spain, Portugal, and Ireland but not Italy (see previous post)). 

The political process that bought about the euro (refer to the posting above) did not set up rigorous checks and balances to make sure that imbalances did not build up.  Furthermore, monetary policy focused solely on inflation of consumer goods rather than asset prices (i.e. the real estate market).  And countries were not willing to give up control of their finances to European bureaucrats.  In the end, if no one is in charge and there is a lack of rules, things are always bound to get out of hand.  Not that politicians have done a good job at fixing that either.  This is why some government such as Greece and Italy now have governments which are not run by politicians.  The solution may be more economist in government.