“Gentlemen prefer bonds” – Andrew Mellon (1855-1937)
They rock your markets
Ever since the global financial crisis exploded a few years back, the bond market has been at the forefront of the media’s attention after decades of always playing second fiddle to the stock market. Be it sub-prime mortgage bonds which were tearing holes out of investment banks’ balance sheets in 2007 and 2008, or Greek sovereign bonds on the verge of default, people are finally waking up to the importance of the bond market within the global economy. But besides being the largest and most important financial market in modern capitalism, the bond market can tell us a lot about the current and future state of the economy in ways that the Dow Jones or Nasdaq could not. And despite the jargon, they are not so difficult to understand. So, without further ado, here’s all you wanted to know about the bond market, in a language you can read (which is English, a language seemingly lost to many economists).
What is a bond?
In the simplest sense, a bond is basically debt. What makes a bond different from other types of debt (say, a loan) is that a bond is tradable, just like any other security such as a stock. So for example, a company can go to a bank and get a $1 million dollar loan, or he can issue $1 million dollars’ worth of bonds (say, 1,000 bonds worth $1,000 apiece) to a potentially limitless range of investors. Bonds are generally preferred over loans as a form of debt because you can issue more of it at one go (no bank is ever going to give anyone a $10 billion loan!), and because it is generally cheaper than a loan. This is because there is less risk attached to it from the lender’s perspective. Whereas the risk of a loan defaulting is borne entirely by the bank that issued it, the risk of a bond defaulting is spread across dozens of bondholders, none of which owns the full amount of the issuance (i.e. no-one bought all those bonds). As a result, a bond will likely fetch a lower interest rate than an equivalent loan, which is clearly better for the issuer. The flip side is that bond issuance is only feasible for government and medium/large firms: a small and relatively unknown firm needs to convince dozens of investors who probably know nothing about the company to buy its bonds. Continue reading
Before I begin my third and last post on the Euro crisis (read the other two here and here), let’s recap on the two main points I’ve made so far. The first point is that a Greek collapse, as catastrophic as it would be for the Greeks themselves, should not in itself endanger the integrity of the Eurozone as a whole. The second point is that if a Eurozone meltdown is going to happen, it will be because a bigger country, most likely Italy, will be the one crashing out. But the economic and political fundamentals of Italy are no worse than Japan’s which has not faced anything even remotely like the fury which the markets have unleashed upon the hapless Italians. So now this leads me to the third point. The Euro crisis is not a crisis of macroeconomic and debt fundamentals but a market crisis of political confidence displaying all the characteristics of a self-fulfilling prophecy.
“If men define situations as real, they are real in their consequences.” – William Isaac Thomas (sociologist)
We might be seeing a lot more of this soon
The self-fulfilling prophecy is without a doubt the most pernicious of all economic phenomena. It is where rationality gets trampled by the animal spirits which more often than not guide the behavior of economic agents, that is, human beings (you are more likely to find the yeti before you find homo economicus). In financial markets, this is all the more evident and all but the most fervent apostles of the efficient-markets hypothesis (which assumes that markets always perfectly factor in all available information) cannot deny that the behaviour of markets often seems to be guided more by euphoria and paranoia than cool, calculating logic. Self-fulfilling prophecies are the catalysts of bank runs, of stock market collapses, and of turning a small country default into an economic Armaggeddon the likes of which capitalism has not yet experienced in its two centuries of existence. In the latter case, it is because no other economic force has the power to turn a problem of illiquidity into a much more dangerous one of insolvency. Ultimately, this is what markets have created out of Greece and nearly done the same for the smaller troubled peripheral countries, mainly Portugal and Ireland. If they do it to Spain or (especially) Italy, we’re screwed. Continue reading
One is on the cross-hairs. The other not quite.
In my previous post, I tried to explain why a Greek collapse (be this in the form of a default or a Euro exit) should not be such a catastrophe to anyone except for the Greeks themselves. The cost of recapitalizing exposed banks would be a fraction of the money spent rescuing the banking system in 2008, and the financial and trade linkages with Greece and the rest of the Eurozone are so meagre that the common currency area should be strong enough to resist one of its weakest members going bust. But of course, that is not the scenario that keeps European politicians awake at night these days. That is Because although a Greek default may appear to be a disaster, a default among one of the Eurozone’s bigger economies – mainly Spain and France – would be economic Armageddon. A scenario like this would dwarf even Lehman’s bankruptcy in the scale of devastation it would unleash upon the global economy, particularly now that governments in the West are too weak to undertake bank bailouts and fiscal stimulus packages like they did back in 2008-09.
But this leads me to the second part of my argument: even the doomsday scenario of an Italian collapse doesn’t hold up to the reality of its economic fundamentals. I’m not saying this means it could never happen. Quite the contrary: if markets believe it will happen, it will happen, all that is needed is to get enough market aversion to Italian debt that Italy’s bond yields are pushed to unsustainable levels. But why should markets believe it? And more importantly, why didn’t markets believe this during the first year of the Euro crisis, when Italian bond yields had been left practically untouched? What has changed during this time?
The answer, quite simply, is nothing. Continue reading
Setting Europe ablaze
As an economist, it’s hard to look at the financial news coming out of Europe recently and not get a sense of déjà vu. In the last few weeks we have witnessed the most severe stock market crashes since the post-Lehman meltdown, a major European bank has needed to be bailed out, the recovery appears to have petered out (on both sides of the Atlantic no less) and frantic discussions are taking place in the upper echelons of power in order to starve off what many believe is another imminent disaster. I don’t want to sound nostalgic but it sure is feeling like the summer of 2008, this time with Europe rather than Wall Street at the center of the gathering storm.
But it’s time to stop and think for a minute. How did we get from a debt crisis in a peripheral member of the Eurozone, to openly contemplate the breakdown of the world’s biggest and most solid economic union? To answer this question, it is necessary to see the current European crisis from two separate angles. The first is through the simple logic of economic fundamentals of debt and growth. As I will try to prove in this post (and its follow ups), the fundamentals are actually not as dire as most people think. However, the second angle is indeed quite frightening. It is that of a market crisis, triggered by a loss of confidence in European policymakers’ ability to effectively address a series of worst case scenarios related to the integrity and future of the Eurozone. Will any of these scenarios actually play out? Only if markets believe they will, thus becoming a textbook case of a self-fulfilling prophecy of apocalyptic proportions. Because if there’s anything to be learned from economic history, it is that when reason and panic collide, panic will always win out.
What follows is my humble attempt at trying to put reason back into the spotlight. So put down the latest newspaper or magazine cover story on the Euro breaking apart, turn off that video with the ranting analyst preaching doom and gloom. Let’s look at the cold hard facts. Continue reading