After they were downgraded in early August, US government bonds gained upward momentum and yields fell below 2% for the 10-year T-note. Japan, which has danced the downgrade tango for years, is now contemplating the next step, this one from AA- to A+, yet 10-year Japanese Government Bonds are yielding below 1%. Downgrades of sovereign bonds of developed countries make good headlines, but their impact on bond markets has been nil. With one exception: the Eurozone.
In the US, there is beautiful clarity: fiscal policies in Congress are such that 36% of every dollar spent has to be borrowed. What these gargantuan deficits—and the resulting mountain of debt—will do to the future of the country doesn’t matter, at least not to the lawmakers. What matters to them is that the Treasury is able to issue and roll over trillions of dollars of debt every year, a feat that is possible only because the Fed can “print” unlimited amounts of money to buy bonds to prop up their values and force down even long-term yields. Quantitative easing, as it’s benignly called, is a mega-force that easily overcomes—due to its “unlimited” quality—any market forces, including the impact of serial credit downgrades.
The shining example of iron-fisted control by central banks and government institutions is Japan. It expanded its public debt from 66% of GDP in 1989 to a mind-boggling 230% in 2011. Its long-term debt got whacked by every credit ratings agency time and again. A+ is waiting in the wings. This year, the government will borrow 56% of every yen it spends.
And yet, JGBs continue to do extremely well. Incomprehensible in a free market. But there is no free market for JGBs. Japan Inc.’s unique institutional setup and cohesive psychology have made it possible to fund 95% of its debt internally. Unruly foreigners only hold 5%.
Eurozone countries lack this dictatorial control over credit markets. At the insistence of Germany, the European Central Bank was given a mandate to maintain the value of the currency, a novel concept for most countries in the Eurozone. By treaty, the ECB couldn’t monetize the deficits of member states. Instead, the countries would be exposed to the brutal discipline of the credit markets, which would enforce, the thinking went, proper fiscal policies. And it sort of worked, for a while.
Now credit downgrades have been hailing down on Eurozone countries, even on those with relatively solid fiscal policies, like Austria, or countries like France, whose deficits and debt levels are lower than those of the US. For some countries, like Italy, funding deficits or rolling over maturing debt at yields they can afford is getting difficult. And Greece is already excluded from the credit markets (though fiscally it’s in better shape than Japan).
But the mere possibility that funding isn’t assured through a central bank makes risk-averse investors leery of the bonds; and risk-seeking investors would demand yields that these countries cannot afford. All because the ECB is governed by laws that were designed to keep it out of the great con game that central banks play everywhere else—though obviously, it has found ways to maneuver around these laws.
Germany and some other countries could agree to allow the ECB to open the spigot all the way and do what the Bank of Japan and the Fed have been doing: buy bonds in massive amounts and include the words “unlimited” and “all member states” in its communications about future debt purchases. It would inspire instant confidence even in the crappiest Greek bonds, and their yields might drop to near zero.
But Germans who were promised a strong euro in return for giving up their sacred Mark would rebel. And so, the ECB will likely toe some imaginary line that keeps member states exposed to the discipline of the markets, and to the impact of credit downgrades. But in most countries, politicians will not be able to make the hard decisions that survival (and success) in such an environment would require. Hence, a crisis that won’t go away.