Monday, November 28, 2011

The Euro Area Is Coming to an End

by Peter Boone and Simon Johnson


November 28, 2011

Investors sent Europe’s politicians a painful message last week when Germany had a seriously disappointing government bond auction. It was unable to sell more than a third of the benchmark 10-year bonds it had sought to auction off on Nov. 23, and interest rates on 30-year German debt rose from 2.61 percent to 2.83 percent. The message? Germany is no longer a safe haven.

Since the global financial crisis of 2008, investors have focused on credit risk and rewarded Germany with low interest rates for its perceived frugality. But now markets will focus on currency risk. Inflation will accelerate and the euro may break up in a way that calls into question all euro-denominated obligations. This is the beginning of the end for the euro zone.

Here’s why. Until 2008, investors assumed that all euro- zone sovereign bonds, as well as bank debt, were risk-free and would never default. This made for a wonderfully profitable trade: European banks could buy government debt, finance it at less expensive rates through funding provided by the European Central Bank, and pocket the spread.

Then credit conditions tightened around the world and some flaws became evident. Greece had too much government borrowing; Ireland had experienced a debt fueled real-estate bubble; and even German banks had become highly leveraged. Investors naturally decided some credit-risk premium was needed, so yields started to rise.

Greece, Ireland, Portugal, Spain and now Italy have large amounts of short term debt that they can’t roll over at low cost. Leading European banks are in the same situation. None of these countries or banks can long bear the burden of their current debt levels at reasonable risk premiums.


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