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Euro crisis: What are they on about?

Europe’s debt crisis is looming large over the global economy. Reports are everywhere you turn, but they are often confusing. They tend to be heavy with jargon and light on background.

The following quote from a story published by Reuters recently is fairly typical.

“German debt prices rose and Spanish bond yields briefly jumped on Tuesday after Spain’s treasury minister said the country was effectively shut out of the market, but investors were reluctant to take new positions before a G7 conference call.”

For most people, that sentence may well have been written in a foreign language. Rising prices, jumping yields, upset Spanish ministers, indecisive investors and seven Gs. What on earth is he saying? Let’s break it down and see if we can make sense out of it.

“German debt prices rose”
Like the rest of us, governments incur debt by borrowing. But unlike the rest of us, they don’t borrow by taking out a loan. They borrow by selling bonds to investors. So when the author talks about debt prices, he’s really talking about bond prices.

Bond prices are initially set by government. Let’s say €100, for example. If an investor wants a 10-year German bond, that’s what he or she has to pay.

In return for his cash, the investor gets an annual payment based on the interest rate associated with the bond. If, for example, the €100 bond is paying a 2.0% interest rate, he or she will get €2 per year for the 10-year life of the bond. At the end of the 10 years, he’ll also get his €100 back. But this isn’t the investor’s only option.
Once an investor buys the bond, he owns it. He can either hold onto it until it matures, 10 years in this example, or he can sell it in the financial market. And that’s where prices change.

A lot of factors influence bond prices, but what matters in this case is risk. When investors get worried about the future, they become less concerned with making money and more concerned with keeping it. As a result, the demand for “risky” assets diminishes and the demand for “safe” assets rises.

Comparatively speaking, German bonds are considered very safe. Most investors believe that the German government will pay its debts. You won’t get rich off them, but you won’t lose your savings either. So when investors get fearful, their demand for the relative safety of German bonds rises. This drives up prices. The same thing has been happening with US, Japanese and Swiss bonds.

“Spanish bond yields briefly jumped”
This part of the quote could just have easily read “Spanish debt prices fell”. It’s the flip side of the risk coin. Spain is confronting a slew of problems, high government debt levels, high unemployment, a contracting economy and an ailing banking system. As a result, investors see a lot of risk in Spain. This diminishes demand for Spanish bonds and drives prices down.

And that is where yields come into the picture. A bond yield is an investor’s return on investment. Yield can be calculated based on a bond’s current price. If the €100 bond we just discussed is paying a 2.0% fixed interest rate and can still be bought for €100 in the bond market, then its yield is 2.0%.

If the bond’s price falls, however, as it has recently in Spain, then the yield will go up. Remember, at the end of the bond’s life, whoever owns it will get a payment of €100. So if price falls and an investor is now able to buy a bond at €95, he still gets an annual payment of €2 plus the €100 in the end. In other words, he’s getting a higher return. This higher return is reflected in the bond’s yield.

The maths can get confusing here, but the principle is straightforward. The important thing to remember is that bond prices and bond yields move in opposition to one another. Think of a see-saw with a kid called Price sitting on one end and a kid called Yield sitting on the other. When Price goes down, Yield goes up.

“After Spain’s treasury minister said the country was effectively shut out of the market”
Yields aren’t just an indication of return for investors. They are also an indication of borrowing costs for governments. Remember, governments have to pay the interest that investors receive.

If Spanish bonds are yielding 6% in the market then any new bonds that Spain sells will have to be pretty close to that rate in order to attract buyers. By saying that his government was “effectively shut out of the market”, Spain’s treasury minister was essentially saying that the interest rate investors wanted to charge on loans was prohibitively expensive for his government. He simply can’t afford to borrow because he can’t afford the interest payments.

There is, arguably, a bit of hyperbole at play here. But the minister is making a valid point. When other European countries saw their bond yields rise above 7.0%, they were forced to seek external financial assistance. In Greece’s case, borrowing costs rose so high that the government was forced to renegotiate the terms of its debt with investors.

“But investors were reluctant to take new positions”
Investors like certainty. If they are fairly confident that prices for German bonds will increase and Spanish bond prices will decrease, they’ll buy and sell accordingly.

What the author is saying here is that the situation in Europe is so uncertain at present that investors are reluctant to make a decision one way or the other. One reason for this hesitance is that policymakers have yet to decide on how best to handle the continent’s crisis.

“Before a G7 conference call”
The Group of Seven (G7) consists of the seven largest economies in the world. These countries have enormous financial resources at their disposal. If they choose to act to support Spain, through a bailout of the country’s banks or large-scale purchases of the country’s bonds, for example, they could drive yields and borrowing costs down, at least temporarily.

You could substitute “European Central Bank meeting” or “International Monetary Fund gathering” for “G7 conference call”. The effect on markets would be largely the same. Any of these institutions has the ability to intervene in such a way as to shift prices.

For example, in the past, the European Central Bank began buying Italian bonds when yields started climbing. This pushed bond prices up, yields down and lowered the country’s borrowing costs.

Pulling it all together
The fear with all this is that if bond yields climb too high and borrowing costs become unmanageable, governments may default on their debts. Because banks and other institutions hold a lot of government debt, this would cause a huge shock to the world’s financial system.

For years now, Europe has been trying to get debt levels under control through a programme of “austerity” – tax rises and spending cuts. Some economists think this cure is worse than the ailment.

By forcing governments to reduce spending and raise taxes in the midst of a recession, they argue, policymakers are actually making the problem worse. They are making less money available to businesses to invest and consumers to spend. This slows the economy. Cruelly, it also means that there is less money available to pay interest on existing debt.

It’s a mess and, unfortunately, one that looks likely to be with us for awhile. At least now you’ll know what it’s all about.

Author

  • Matt spends part of his weekends writing a weekly preview of the global economy for the Mail & Guardian and a detailed preview of Brazil, Russia, India, China and South Africa's outlook for The BRICS Post. During the week, he is a senior economist and head of sales for NKC Independent Economists. He also manages Exchange Data International's and Softek Computer Services' businesses in South Africa. Born and raised in the USA, he worked for the U.S. Treasury Department and Federal Reserve Bank of Boston before moving to Cape Town with his wife, Maya, and Jack Russell terrier, Hazel. They’ve since been joined by two sons, Sebastian and Gabriel, both born in the Mother City. Follow Matt on Twitter: @MattQuigley.

13 Comments

  1. Ginger Ginger 14 June 2012

    Thank you so much Matt. I have always thought I am one of those people who should know what is going on,but have been too embarassed to ask. You really have put things in perspective for me. Much appreciated.

  2. Garg Unzola Garg Unzola 14 June 2012

    Sweet, thanks very much for explaining some jargon in simple terms.

  3. Occams Razor Occams Razor 14 June 2012

    I think I understand it a lot better now, and that’s not just Dunning Kruger effect! You did explain it well…Just a question, if the solution is not “austerity” then what else? or are we well and truly cooked?

  4. Will Will 15 June 2012

    Its a tough situation, the government has basically control over fiscal policies, basically they can play around with Government spending and taxes. The central bank plays around with money supply (monetary policy) this directly affect the interest rate (more money supply would lead to lower interest rates etc), which has an effect on investment and consumer spending.

    In a bad recession unemployment would usually be high so the government would try to use its powers (tax rate or government spending) to stimulate consumer spending and thus decrease unemployment (bigger demand for products, output increases and that requires labor).

    Take America as an example, the government is using both policies to artificially keep the economy going. Huge Government spending and low tax rates, huge money supply. The only reason these policies are still working for them is because their currency is still keeping its value (reserve currency). In reality they are devaluing their currency on a huge scale by printing money out of thin air. We are going to see a huge slump in the American and world economy as soon as trust in the American dollar falls. Just my 2 cents worth.

  5. The Creator The Creator 15 June 2012

    Nicely put. However, you leave out the strong evidence that this whole process is being engineered to transfer money from the poorer and weaker countries within the EU to the richer and stronger ones. And that within the countries practising “austerity”, the loud pedal is always on spending cuts rather than tax increases — the lack of tax increases being the reason why deficits are growing rather than shrinking. Also, of course, the spending cuts are selective — Greece has been instructed not to cancel its gigantic arms purchases, because the arms are being bought from the rich EU countries which don’t want to lose the revenue, even though Greece has no conceivable use for the weaponry it is buying (except to go to war with its NATO ally, Turkey).

    In other words, you are right to say that things are stuffed up, but the stuffing was planned long ago by the turkey-farmers in Berlin and London.

  6. HD HD 15 June 2012

    Nice.

    Of course there are plenty of reasons/counter-arguments to question the extent of “austerity” measures in Europe,

    http://www.nationalreview.com/corner/299373/debate-over-austerity-continues-veronique-de-rugy#

    question the type of austerity being followed

    http://www.latimes.com/news/opinion/commentary/la-oe-derugy-austerity-gets-bad-rap-20120517,0,1723259.story

    http://neighborhoodeffects.mercatus.org/2012/04/26/does-uk-double-dip-prove-that-austerity-doesnt-work/

    and seriously worry about the current proposals and circus that is the EU:

    http://www.youtube.com/watch?feature=player_embedded&v=TN_1mF-3JTI

    Unfortunately the mass media is full of the economic hubris from political hacks like Krugman and institutional / establishment economist that all have a stake in pushing Keynesian solutions so that their plutocracies and financial empires can be re-inflated and bailed-out.

  7. bernpm bernpm 15 June 2012

    To add to the European crisis is a more prominent line of thinking in certain countries to abandon the Euro idea and go back to financially independent nations.

    Germany, the most powerful financial member, is against. Many smaller countries seem to move toewards this as the membership of the “Euro block” becomes to expensive for them while loosing control over their own finances.

    In the background come te noises of the US rating houses who throw the odd curved ball in the middle of this “debate”. They seem to serve the US financial world more than helpng the Europeans: reduces the flow of US money to Europe.

  8. Lesego Lesego 15 June 2012

    @Will, Of course America will never experience hyperinflation no matter how much banknotes they print as the Dollar is the Global currency. But although its not the case with the former Spain, Greece and Portugal currencies, were they able to print their own money, it would be a cushion that would at least reduce their current economic crisis.

  9. Brent Brent 15 June 2012

    Read a report today that French banks are limiting the amount of cash you can draw, to E1000 or some at E1500 and also placing ceilings on ATM drawings. Does this mean France is next on the Euro crisis list?

    Brent

  10. blogroid blogroid 15 June 2012

    Thank you for a most useful blog.

  11. Peter L Peter L 16 June 2012

    @Matt
    As you well know, no country or Politician plans for or promotes as first, second or even third choice a policy of austerity – it is forced on them by circumstances (normally of their own making – past policy decisions).
    Politicians who implement austerity measures have a very high risk of being voted out of office , which is why it is a “last resort” for them..
    Let’s see what happens with the Greeks tomorrow!

    If the Greeks, and / or Spanish, Portugese Irish etc pull out of the European monetary union and revert to sovereign currencies, immediate and drastic currency devaluation is a likely outcome.
    The global banking system would come under pressure, and banks would stop lending to each other.
    Result – world-wide recession.

    Wild lending and spending, poor regulation and risk managment, and excess debt have got the likes of the PIIGS nations into the trouble they are now in.
    The big problem is that the current “solutions” of quantitative easing and bail-outs result in MORE DEBT!

    @Will
    The USA is little or no better off than the Eurozone.
    Their currency IS in fact devalueing against the stronger currencies of the world – Swiss Franc, Norwegiean kroner, Japanese Yen etc.

    If and when commodities in general and Oil in particular is no longer traded in USD $, the USA will be headed for major problems.

    Try looking at their budget and trade deficit – it is unsustainable in the long term.

  12. Paul Fanner Paul Fanner 18 June 2012

    What does the horizontal axis on the blog statistics represent? It is presumably time, but what are the units? And why the peaks with only one or two data points in them?

  13. Hi, we are trying to find guest bloggers for Euro Crisis Explained. If you would like to submit something get in contact. Thanks!.

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