German bonds hold the secret to the eurozone crisis


31 May 2012
Stephen King, Group Chief Economist

Stephen King

Imagine – if you possibly can – that the eurozone crisis is finally resolved. The dust has settled. The euro is still in one piece. How would we have got there?

A lasting solution will require a shift in belief. Belief, in turn, can be measured through bond spreads and, in particular, the level of German yields.

Many investors now expect – and more than a handful of policy makers now fear – that the end
is nigh, that the euro is on its last legs. As that belief festers, its self-fulfilling qualities threaten the euro's survival.

The consequences of that belief are all around us. Slow motion bank runs, widening sovereign spreads and biting recession are symptoms of an underlying fear that the euro will crumble.

The fear is most obviously expressed through capital flight. One oddity of the crisis to date is that, while some countries in the eurozone are suffering enormously, others are doing perfectly well, largely thanks to capital heading northwards. Thus whereas the cost of borrowing is painfully high in Spain, it is ridiculously low in Germany.

Capital flight has created a quasi-currency market within the single currency area. If investors fear euro break-up, they'll invest today in anticipation of where newly-independent national currencies might head tomorrow. No one has any sure way of working out where a future German euro might trade versus a future Spanish euro, but it's not hard to believe that the German euro would appreciate dramatically against its southern rivals.

That belief is precisely why we're witnessing capital flight. Why would investors choose to hold Spanish assets which, in a post-euro world, might lose their value remarkably quickly when they could, instead, opt for German assets which might appreciate thanks to the introduction of a German euro?

A lasting political commitment to the eurozone would encourage capital to head south again.

Even if the initial probability of a euro break-up is deemed to be low, it might nevertheless be high enough to trigger the capital flight which, day by day, increases the likelihood of eventual euro break-up.

Other than the copious use of effective capital controls, the only way to stop capital flight is to provide a cast-iron political commitment that the euro will survive (no one, after all, believes that the Californian dollar will appreciate against the Illinois dollar). That's not easy. Imagine, though, that the commitment is provided and that investors believe the politicians are serious. What would then happen?

The flow of capital would reverse. No longer would there be any reason to treat the eurozone as a quasi-currency market. And the narrative which has so bedevilled the eurozone until now would disappear in a puff of smoke.

That narrative is based on the idea of good creditors and bad debtors. The idea is simple. It is also dangerously wrong. Spanish yields are high, apparently, because Spain finds itself in a poor fiscal and banking position whereas German yields are remarkably low because the Germans have delivered the right reforms. It follows, therefore, that other countries in the eurozone should become more Germanic.

It's a nice idea but also utterly implausible. Not all countries in the eurozone can benefit from 10 year bond yields at below 1.3 per cent. German yields are down at this ludicrously low level because of capital flight, not economic fundamentals.

It follows, then, that a lasting political commitment to the eurozone would encourage capital to head south again. German bond yields would have to rise even as Spanish yields fell. And that conclusion, in turn, provides a clue as to what a lasting political solution might look like.

It's likely to include some form of common bond issuance alongside a low-level fiscal union and, perhaps, a eurozone-wide deposit insurance scheme for the banking sector. Institutional arrangements would need to be established to stop the process of capital flight unfairly creating winners and losers leading, in turn, to the rise of political extremism.

In other words, there needs to be burden-sharing. The winners have to give something back. Germany cannot insist on austerity for others while benefiting from capital flight. The flow of capital has to be reversed triggering higher German bond yields. If and when that happens, policymakers will finally have convinced themselves and, indeed, everyone else that the euro will survive.

And what if German yields don't rise? Barring a massive bout of ECB-led quantitative easing, two explanations spring to mind. Either the euro is left teetering on the brink or the recession in southern Europe has begun to drag Germany down too.

Policies designed to save the euro should be judged by the German yield yardstick. Higher German yields should be welcomed everywhere. And that includes Berlin and Frankfurt.

Stephen King originally wrote this article for the Financial Times newspaper, published on 31 May 2012.