The Downside of Imperial Collapse
When Empires or Great Powers Fall, Chaos and War Rise
The ongoing eurozone debacle has driven home certain straightforward lessons: the fiscal rules enshrined in the EU's 1997 Stability and Growth Pact had almost no teeth, government bonds of EU nations are not a risk-free asset, and voters do not readily tolerate economic austerity. Beyond these, however, the last few years have also contained subtle lessons about the relationship between governments and capital markets. More specifically, they have shown that our understanding of the pressures that private capital markets place on governments is incomplete. Although holders of government debt certainly would react markedly to a change in the membership of the eurozone, they would not likely react strongly, or over the longer term, to many other government policy decisions and political outcomes. And these reactions have varying consequences for governments, depending on how governments have managed their debt profiles. Were the move toward eurobonds to come to fruition, some of these debt management decisions presumably would be made by EU-level, rather than national, authorities.
All governments borrow money, but they structure their borrowing in different ways. In the late 1980s and early 1990s, many developed nations, including France, Germany, Ireland, and the United Kingdom, began to establish autonomous debt management offices. These offices are often located within the country's central bank or finance ministry, and are staffed by experts in capital markets, not in politics. The mandates of these offices typically include two sometimes contradictory objectives: minimizing the governments' borrowing costs and keeping rollover risk (the risk associated with refinancing debt) at an acceptable level. Debt managers who focus largely on minimizing borrowing costs issue more short-term debt than long-term debt, especially when short-term borrowing is significantly cheaper than long-term borrowing. (Such a steep yield curve occurs, for example, when investors expect significant inflation, which erodes the real value of bond repayments.) When debt management offices focus on reducing rollover risk, however, they borrow at longer maturities and in a way that is evenly distributed over time. That strategy means that governments will need to finance their debt less frequently. Many debt management offices attempt to balance these two objectives; often, the weight given to each varies across countries and over time.
Among European countries, for example, the average time to maturity of government debt varies widely. National debt management practices are not static over time, nor do they necessary follow one pattern in the European core and another in the European periphery. The United Kingdom's Debt Management Office recently reported that the average maturity of its debt was a high 14.5 years as of March 2012, up from 13.5 years in March 2011 and 13.1 years in 2010. That same year, Portugal's average was 5.8 years, Germany's was 5.9, Belgium's was 6.5, the Netherlands' was 7, France's was 7.1, and Italy's was 7.2. And many of the peripheral European countries had increased their average maturity significantly during the 2000s, issuing longer-term bonds to replace maturing shorter-term debt. This strategy was facilitated by investors' confidence that, as members of the eurozone, these countries' assets were relatively safe. In 2000, Portugal's average maturity was 4.6 years and Italy's was 5.7 years. (Most peripheral countries' average maturities reached their highs in 2008, before falling again.) Indeed, recent calls for eurobonds are an attempt to recapture some of the EMU bonus that accrued to peripheral nations in the 2000s; eurobonds would pool risk across participating nations, resulting in lower rates for peripheral nations but higher ones for core EU members, such as Germany.
So how does debt management policy play into the eurozone-wide economic slowdown? News accounts today often anticipate that political decisions (especially bad ones) will result in increased interest rate premiums on government debt held as bonds. In mid-April, for instance, the Financial Times suggested that "French fear is returning to the markets." In advance of the first round of France's presidential elections, the paper quoted an investment analyst as warning that, were Hollande to win and to pursue fiscal expansion, "the bond vigilantes will quickly cross the border from Spain to France." In late May, The New York Times noted that the gap between German and Spanish bonds had reached a euro-era record, as investors reacted to the European Commission's suggestion that it was prepared to show flexibility toward Spain's fiscal target.
What these accounts describe are actually secondary market reactions -- that is, when some political decision or event leads to a change in the price that buyers are willing to pay for already issued government bonds. Secondary reactions have the potential to generate long-term changes in government bond prices, but only when they translate into changes in demand for auctions of new government debt.
And this is where debt maturity comes into play: if a government's debt has a relatively short average time to maturity, the government will need to refinance its debt more frequently. Doing so increases the chances that a government will have to face the markets when some negative event has increased investors' perceptions of risk. (Governments with higher levels of debt also will usually need to face markets more often, simply owing to how much they have borrowed.) Governments whose bonds take longer to mature are more likely to be able to wait out a period of turmoil. Similarly, governments with a gap in their rollover calendar -- such as Italy, which has almost no medium- and long-term maturations in May and June -- can sometimes avoid negative market conditions.
Italy certainly has not been immune to market pressures, but its relatively longer maturity of debt (seven years at the end of 2011, contrasted with Greece's 6.3 years) afforded it additional leeway vis-à-vis capital markets. Although borrowing long-term can be costlier for governments in terms of interest rates, it also can increase their autonomy from investors. Of course, debt maturities are somewhat the result of past economic policies: governments with weak credit histories and poor fundamentals often find that borrowing long-term is considerably more expensive than selling short-term debt. But past economic policies do not completely predict current maturity profiles; these profiles also depend on how governments prioritized insulation from market pressures versus lower borrowing costs. As such, the extent to which a government has to face the markets today depends on how it chose to structure its debt management yesterday. Europe's crisis is therefore likely to convince governments and debt management offices to privilege longer maturity structures over low-cost financing. Should eurobonds come to pass, we might expect them to have relatively long maturities (assuming, of course, that investors were willing to buy such long-dated, newly designed securities without demanding high-risk premiums). Indeed, this is exactly the lesson that many Asian and Latin American nations took from the financial crises of the 1990s: during the 2000s, the average maturity of public debt increased markedly in both regions.
The second lesson from recent events in Europe is that, even in the midst of deep economic turmoil, private investors are less able to constrain governments than many believe. Media reports regularly suggest that holders of government debt anxiously await every crisis-time parliamentary debate and policy decision. These investors supposedly react negatively whenever the legislature fails to mandate new rules for revenue collection, or when a parliament fails to raise the minimum retirement age, and positively if the government enacts a policy that limits health care coverage for pensioners or reduces levels of unemployment compensation.
In reality, though, the market does not work that way. Since the 1990s, financial markets have not really cared about government's individual policy decisions. Then, as now, purchasers of sovereign debt simply wanted reassurance that governments would repay their debt and were content to ignore exactly how governments managed to do so. So, in the run-up to the creation of the European Monetary Union, investors paid close attention to whether Italy could reduce its budget deficit to three percent of GDP, as mandated by the EU, but not to how -- whether through cuts in infrastructure spending, cuts in pensions, increased taxation of firms, or increased taxation of middle-income households. Once Italy cleared the three percent bar, joining the eurozone was a done deal.
It was investors' very agnosticism that made the EMU so beneficial for members to begin with: governments that adopted the euro were considered nearly equal when it came to currency and inflation risk. Greece, Italy, Ireland, and Portugal could borrow at relatively low interest rates, especially when compared with non-EMU members with similar economic fundamentals. But in 2009, after about a decade of convergence in sovereign bond rates among eurozone governments, rates started to diverge quickly. By 2010, the standard deviation of long-term interest rates in the eurozone was 21 times larger than it was in 2007. In other words, investors' rules for assessing sovereign borrowers had changed; investors had started to pay attention to deficit and debt levels, especially among the hurting countries in the periphery.
And yet financial markets continue to care more about the big picture. Yes, the Greek government was repeatedly warned to pass a package of spending cuts. And yes, the eurozone has been pushed toward lower fiscal deficits, as well as toward strengthening banks' balance sheets. But the investors also seem uncertain about how best to achieve such outcomes. (See, for further detail, the work of the political scientist Henry Farrell and the economist John Quiggin on the rise and fall of Keynesianism.) All investors suspect that default, domestic political upheaval, or the breakup of EMU could be economically disastrous. But they are divided about whether the best response is fiscal stimulus (as they seemed to want early in the crisis), austerity (as markets have seemed to demand more recently), or perhaps an intermediate strategy. Market actors' uncertainty over what the right model is means that governments have significant autonomy. Accordingly, the new French President François Hollande's vows to pursue a more socialist economic policy have been met in the bond markets with a yawn.
It is useful to remember that professional investors are evaluated based on their performance, relative to a peer group, in a given quarter or year. Their time horizons are short, and their task is to predict how other participants in a market will respond to a policy change (rather than how things will turn out in a decade). Given all that, during times of upheaval, it becomes hard to predict how "the market" will evaluate specific policy decisions. If some investors like spending cuts, while others worry that cuts will endanger economic recovery, then the overall market reaction will be quite muted.
Today, if governments start to offer a clear sense of what a good policy response might be -- if they can make a case, for example, that certain types of government spending should be maintained, even if they lead to short-term increases in deficits and debt -- then they might again be able to lead market forces rather than be led by them. Doing so would require European governments to speak collectively, which makes the response of other European leaders to Hollande's economic policy proposals, as well as to German Chancellor Angela Merkel's suggestion of a new set of Europe-wide rules for national fiscal policies, all the more important. Whether Europe's leaders ultimately agree on greater fiscal restraints, on an economic stimulus program, or on some intermediate course, agreement among governments is key. Such an agreement, almost regardless of its substance, would allow governments to lead markets, rather than the reverse.
Moreover, as long as market actors continue to focus on the big picture, investors will respond more to overall outcomes, such as whether or not budget deficits can be slashed, than to specific policy decisions. This isn't to say that overall outcomes are easy to achieve politically or economically, but policymakers would do well to worry less about capital market reactions to specific measures. Instead, they should worry about reassuring or protecting particularly hard-hit, or politically vocal, domestic groups, as well as about appropriate management of public debt profiles. And, to return to the example of France, capital markets do not necessarily hate left-leaning governments: in this era of uncertainty, markets may care less about the socialist label and more about whether Hollande is able to build a coalition (at home as well as in Europe) to move forward on economic policy.