What’s wrong with the euro? Again and again, we end up discussing its instability and the relentless attempts by financial markets to challenge its existence by betting against the government bond markets of peripheral member countries.
This is happening again as interest rates begin to rise, putting pressure on risk premia. And again, the European Central Bank will have to step in and announce a new tool to counter market fragmentation.
Some might say there is skepticism about a currency without a single fiscal policy, a plethora of institutional arrangements and committees, many presidents and no political unity. Many economists still believe that the experiment of integrating different nations with different languages, cultures and economic structures is doomed to failure. This despite the repeated political intention to maintain the unity of the euro, at all costs.
Some point to the lack of strong political commitment to integration, despite welcome solidarity during the pandemic. For example, Eurozone policymakers have been discussing the final stages of banking union for the past ten years and have yet to reach an agreement.
Others point to the irresponsible fiscal behavior of some peripheral eurozone countries and that some degree of instability is the inevitable price for maintaining fiscal discipline and avoiding moral hazard.
There is, instead, a much simpler explanation.
Trying to get higher returns always involves higher risks. An option-type product offers the possibility of higher returns while limiting potential losses, but investors generally have to pay a premium for this payout feature. Not in the euro zone.
The yield spread between core and periphery government bonds behaves like an option, and there is no premium to pay (other than negative carry, which makes market timing essential).
Also, unlike emerging market bonds or similar risk products, liquidity is plentiful. The Italian bond market serves as a barometer for the entire periphery. Even under the stress of the sovereign debt crisis in 2011-2012, it continued to perform well and provided investors with much-needed liquidity for their options-type strategies.
If needed, policymakers are willing to provide last-resort cash. In 2011, when spreads were under pressure, the ECB used the securities markets program to restore proper functioning of monetary policy transmission. The SMP was a sterilized intervention to respond to the difficulties of “certain segments of the financial market to absorb transactions without too much effect on prices”. It was conditional and temporary. In other words, it was like saying to investors, hurry up while it lasts.
With the potentially unlimited intervention provided by outright monetary operations and then by the various ECB asset purchase programs, spreads have narrowed since 2012. But political tensions and other events have produced recurring spikes in the spreads. spreads. Such was the case when a maverick government took office in Greece in 2015 and when an anti-establishment government was formed in Italy in 2018. Such behavior reinforces the optionality of betting against the periphery. If the timing is right, there is always the potential for outsized returns without paying option premiums or committing a lot of capital.
Market discipline is a necessary mechanism, especially if complex and articulated fiscal rules have not been effective in preventing fiscal drifts. But there must be a better way. Many possible solutions have been put forward in the past, but it is ultimately about completing the unfinished business of the current fragile economic and financial integration.
When I was at the Italian Treasury, I had a fascinating exchange with the chief economist of an American primary fund on the institutional framework of the euro. Suddenly he stood up, pointing his finger at me and saying, “You have created a monster!
The euro is not a monster. On the contrary, it is the best experience to achieve peaceful economic and, at some point, political integration between different sovereign nations in order to improve the welfare of citizens. Unfortunately, embedded in a well-targeted project is a hidden and monstrous mechanism that produces instability.
On July 21, the ECB will unveil a new tool to reduce or limit market fragmentation. There are many expectations as well as significant uncertainty about its characteristics and potential effectiveness. In any case, it will be yet another band-aid.
One prediction is sure: no matter how effective, the financial markets will again bet against the euro at some point.
Lorenzo Codogno is Visiting Professor in Practice at the London School of Economics, and Founder and Chief Economist of LC Macro Advisors.