Europe's fundamental problems would be easier to manage with calmer financial markets, writes Daniel Gros, director of the Centre for European Policy Studies.
The following contribution is authored by Daniel Gros, director of the Centre for European Policy Studies.
"The euro zone is being thrown into turmoil by a collective rush to the exits by investors. Yields on government debt of peripheral eurozone countries are skyrocketing, because investors do not really know what the risks are.
Officials want to be reassuring. Investors should not worry, they argue, because the current bailout mechanism – the European Financial Stability Facility (EFSF) – has worked so far without any haircut for bondholders, and will continue to be applied until about 2013. Only after that date would any new mechanism open the door for losses for private investors, and only for debt issued after that date.
But markets do not trust this message – and for good reason: it is not credible, because it makes no economic sense. After all, the claim that the risk of loss will arise only for debt issued after the new crisis-resolution mechanism starts in 2014 implies that all debt issued until then is safe, and that insolvency can occur only in some distant future, rather than now, as in Greece and Ireland. In effect, EU officials are saying to investors, 'Whom do you believe – us or your own eyes?'
Moreover, for too many investors, Portugal, with its poor growth prospects and insufficient domestic savings to fund the public-sector deficit, looks like Greece. And Spain clearly has to grapple with its own Irish problem, namely a huge housing over-hang – and probably large losses in the banking sector – following the collapse of an outsized real-estate bubble. The problems of Portugal and Spain might be less severe than those of Greece and Ireland, but this apparently is not enough to induce investors to buy their government debt.
A danger these countries share is thus the acute danger of large-scale runs on their banking systems. So far, investors trying to exit first have been made whole. Holders of Greek debt maturing now are repaid courtesy of the €110 billion bailout program, and holders of Irish bank bonds have been given a guarantee by the Irish government, whose promises have in turn been underwritten by the EFSF. The EFSF will also provide funds to ensure that Irish banks’ depositors can get their money back today.
The problem with this approach is that it creates the wrong incentives. Investors have now learned that the first to sell will avoid losses. The situation resembles that of a crowded cinema with only one exit. Everyone knows that in case of fire, only the first to leave will be safe. So, if the exit is small, even the faintest whiff of smoke can trigger a stampede. But if the exit looks comfortably large, the public will be much more likely to remain calm, even if parts of the room are already filling with smoke."
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(Published in partnership with Project Syndicate.)