Paul De Grauwe with Yuemei Ji (DGY from now on) provided interesting correlations of economic variables with euro spreads of Southern countries with Germany. Their statements in what follows are in italics. Here are my reasons to disagree at least partly with their analysis or to put some obvious doubts in readers’ minds.

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DGY: “The decision by the ECB in 2012 to commit itself to unlimited support of the government bond markets was a game changer in the eurozone crisis.”

Is this an assumption or an empirically proven fact? By simply looking at the spread with Italy one would notice that the spread between Italy  and Germany prevailing at the end of July (Draghi’s speech was at the end of July, the 26^th to be precise) was not such a game changer. Italian spreads were at the same level (around 450 basis points) one month later, at the end of August.

Rather, what seems to be the start of a structural decline sees its beginning in the first days of September (350 basis points). What happened at the beginning of September? One might argue not so much that the ECB changed its mind, but that Mrs. Merkel did. According to the Spiegel on Line of September 10, 2012, one can read some interesting passages which I here quote (my bold):

“Attentive observers already noticed the chancellor’s apparent change of heart two weeks ago. Merkel, whose father was a pastor in communist Eastern Germany, has suddenly discovered a deep affection for the downtrodden people of Greece. She compassionately expressed empathy for “what many in Greece have to suffer,” and said that “it does make one’s heart bleed.” … One doesn’t need to be a rocket scientist to see through Merkel’s maneuver: The chancellor wants to buy time. She hopes to calm the general public and the notoriously nervous financial markets through meditative repetition — and ultimately create the impression that it actually matters what the troika finds out during its mission to Greece. But it doesn’t. In reality, Merkel has already made up her mind. After long hesitation, she has sided with French President François Hollande and the European Commission. Merkel’s newfound determination to rescue Greece is a remarkable U-turn for the chancellor. Until recently, Merkel was prepared to drop the country if it failed to meet its commitments. But she now regards a Greek departure from the euro zone as entailing too many risks. In the Chancellery in Berlin, officials fear that such an outcome could trigger a domino effect like the one caused by the Lehman Brothers bankruptcy in September 2008. But the political costs are also too high for Merkel. If Greece withdrew from the euro zone, her advisers fear that this could mean that it would eventually be necessary to create a common “debt union” to stabilize problem countries like Italy and Spain. It would be a paradoxical situation: Germany would take a hard-line approach with Greece, but might subsequently have to accept jointly issued euro bonds, which German voters widely oppose.”

DGY argue that “While the ECB finally acted in September 2012, it can also be argued that had it acted earlier, much of the panic in the markets may not have occurred and the excessive austerity programmes might have been avoided.” But why did the ECB finally act? Let us read from the Spiegel a bit more:

“The enormous political pressure in this direction is exemplified by the ECB’s controversial decision last Thursday to purchase, if necessary, unlimited quantities of sovereign bonds from struggling euro-zone member states”. So it does seem that one possible alternative interpretation is that the ECB was the follower and Germany the leader in the spreads movements and the beginning of a decline.

Why, you might ask, is this an important difference with respect to DGY’s story? It’s simple: because it implies that what might really drive down the spreads and up markets beliefs is not so much a (yet to occur) ECB expansive monetary stance but rather  how much is Europe willing to avoid a recession in debt ridden countries.

But let us follow on DGY’s argument.

According to one theory, the surging spreads observed from 2010 to the middle of 2012 were the result of deteriorating fundamentals (e.g. domestic government debt, external debt, competitiveness, etc.). The implication of that theory is that the only way to bring these spreads down is by improving the fundamentals, mainly by austerity programmes aimed at reducing government budget deficits and debts.  

Another theory, while accepting that fundamentals matter, recognises that collective movements of fear and panic can have dramatic effects on spreads. These movements can drive the spreads away from underlying fundamentals, very much akin to the way stock markets prices can be gripped by a bubble pushing them far away from underlying fundamentals. The implication of that theory is that while fundamentals cannot be ignored, there is a special role for the central bank that has to provide liquidity in times of market panic.

What about the third theory? What if spreads go up if markets observe chances of economic growth disappear? What if among fundamentals it is the one forgotten by DGY, GDP growth, the one most likely to explain spreads’ movements? And what if the worse are growth prospects the higher is the spread in a given country and across countries? After all, since when lenders do not care about growth prospects of borrowers?

DGY then find that:

“Countries whose spread had climbed the most prior to the ECB announcement experienced the strongest decline in their spreads – a remarkable phenomenon.”

Once again, is it only possible that we could rephrase the sentence as:

“Countries whose spread had climbed the most prior to Merkel’s change of heart experienced the strongest decline in their spreads – a remarkable phenomenon.” ?

Certainly.

Again DGY: “By taking away the fear factor, the ECB allowed the spreads to decline. We find that the decline in the spreads was the strongest in the countries where the fear factor had been the strongest.”

Let us rewrite it as:

“By taking away the recession factor, Mrs. Merkel allowed the spreads to decline. We find that the decline in the spreads was the strongest in the countries where the recession factor had been the strongest.”

Credible? Well, why not!

Now let us totally agree with DGY’s following statement:

“What about the role of fundamentals in explaining the decline in the spreads observed since the middle of 2012? … the decline in the spreads observed since the ECB announcement appears to be completely unrelated to the changes of the debt-to-GDP ratios. If anything, the fundamentalist school of thinking would have predicted that as the debt-to-GDP ratios increased in all countries, spreads should have increased rather than decline.”

We agree. And actually an important policy advice we take from this is: forget about those theories that say that spreads will decline when you lower debt through, as often suggested in Italy, privatizations or other asset sales.

But here is again where we disagree with DGY who claim that:

“From the previous discussion one can conclude that a large component of the movements of the spreads since 2010 was driven by market sentiment. It was fear and panic that first drove the spreads away from their fundamentals. Later as the market sentiment improved, thanks to the announcement of the ECB, these spreads declined spectacularly.”

Which we rewrite:

“From the previous discussion one can conclude that a large component of the movements of the spreads since 2010 was driven by market desperation with policies. It was lack of growth prospects that first drove the spreads away from their fundamentals. Later as the market desperation subsided, thanks to the stance of Mrs. Merkel, these spreads declined spectacularly.”

DGY then make another important claim:

The fact that spreads were largely unrelated to real economic fundamentals does not mean that they were not without influence for the real economy. The main channel of influence of the spreads was through policy reactions. As the spreads increased due to market panic, these increases also gripped policy-makers. Panic in the financial markets led to panic in the world of policy-makers in Europe. As a result of this panic, rapid and intense austerity measures were imposed on countries experiencing these increases in spreads.

Indeed we believe that spreads have everything to do with real economic fundamentals. But not in the manner that DGY claim. He claims that panic in financial markets led to panic among policy makers? We believe the reverse is true. The panic of policy-makers led them to choose the wrong policies and this led to panic in financial markets. Austerity measures were indeed taken as a result of panic: but that panic did not originate from market fears communicated to policy makers, but from a basic incapacity of European leaders and a lack of knowledge on how to deal with a crisis of huge proportions that never before had hit the new currency union. That incapacity has made markets nervous and unstable.

PDG: “The higher the spreads in 2011, the more intense were the austerity measures.”

Piga: The more intense were the austerity measures, the higher the spreads in 2011.

DGY then conclude:

“Two conclusions can be drawn from the previous analysis. First, the power of the ECB to counter market sentiments of fear and panic is great. Up to now this power has been exerted only by announcement. Not a single shot was fired. It is clear, however, that if market sentiments were to turn around again, the ECB would be forced to fire, i.e. to actually intervene. Otherwise it would immediately lose its credibility and its power.”

What if instead, this power of the ECB comes from the stance of euro leaders, as represented in the most evident way by Mrs. Merkel? Then it would mean that it would be in Mrs. Merkel hands to actually intervene with all guns at her disposal to fire: fiscal policy (no more austerity in the euro area) and monetary policy (by calling on the phone the Bundesbank representative and asking him to let go rates a bit more?).

“Second, the evidence provided here suggests that since the start of the debt crisis financial markets have provided wrong signals. Led by fear and panic, they pushed the spreads to artificially high levels and forced countries lacking the cash into intense austerity producing great suffering in these countries. They also gave these wrong signals to the European authorities, in particular the European Commission that went on a crusade trying to enforce more austerity. Thus financial markets acquired great power in that they spread panic into the world of the European authorities, who translated the market panic into enforcing excessive austerity.”

What if market signals were right the whole time of the crisis? What if the wrong signals were instead given by stupid austerity policies chosen at the political level? Well then we would have to totally disagree with DGY’s last statement:

“In order to avoid misunderstanding: we are not saying that southern European countries will not have to go through austerity so as to return to sustainable government finances. They will have to do so. What we are claiming is that the timing and the intensity of the austerity programmes have been dictated too much by market sentiment instead of being the outcome of rational decision-making processes. There can be little doubt that the governance of the eurozone will have to change in order to avoid being taken hostage again by volatile market sentiments.”

And we would instead argue that:

“In order to avoid misunderstanding: we are not saying that southern European countries will not have to go through austerity so as to return to sustainable government finances. They will have to do so. What we are claiming is that the timing and the intensity of the austerity programmes have been dictated too much by policy mistakes instead of being the outcome of rational decision-making processes. There can be little doubt that the governance of the eurozone will have to change in order to avoid being taken hostage again by erratic and dumb policy choices.”

Thank you Ale