Why the EU Summit Decisions may Destabilise Government Bond Markets [nakedcapitalism]


By Paul De Grauwe, Professor of international economics, University of Leuven, member of the Group of Economic Policy Analysis, advising the EU Commission President Manuel Barroso, and former member of the Belgian parliament. Cross posted from VoxEU

Among the questions still remaining since last week’s summit of European leaders is whether the new measures will stabilise government bond markets. This column’s answer is ‘no’.

 

This was the nth summit meeting of European leaders billed as finally solving the Eurozone crisis. Yet there were a number of important and useful decisions taken at last week’s summit:

A new banking union with a European supervisor that has some teeth; and
the possibility of organising recapitalisations of banks at the European level.
These are both positive steps. The last one in particular is important.

One of the main weaknesses of the Eurozone lies in the fact that banking problems have to be resolved by the national government where the banks are located. As a result, insolvency of local banks threatens the solvency of the national government, leading to a vicious circle of interacting solvency crises of local banks and the local sovereign. Cutting the link between the two is therefore key to creating a more stable financial environment in the Eurozone.

Banking union: Devil in the detail

While the principle of a European mechanism for resolving banking crises is now accepted, major practical problems of implementation of that principle lie before us.

• What will be the supervisory powers of the ECB?
• Who will run the recapitalised banks?
• What if a bank has to be nationalised?

These and many other practical questions will pop up on the road to implementing the new principle.

The European Stability Mechanism

The focus of this column, however, is on the new role that is given to the European Stability Mechanism (ESM), otherwise known as its bailout fund, that should start its operations very soon.

In addition to its conditional financial assistance to member countries, the ESM was given two new tasks.

• The first one (that I just discussed) is that it will be able to directly recapitalise troubled banks.
• The second one is that it will be allowed to buy government bonds in the secondary markets so as to prevent further destabilising surges in bond rates.

These are eminently important objectives.

Surely something must be done about the inexorable rise in the sovereign bond rates of a number of Southern European countries? These surges in the interest rates are only partly the result of bad fundamentals. For countries like Spain and Italy, a significant part of the increases in the spreads is the result of fear and panic in the markets that have the potential of driving countries into bankruptcy in a self-fulfilling way (De Grauwe and Ji 2012).

The question then is whether the ESM will be able to stabilise the government bond markets. My answer is ‘no’.

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