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A Bucket of Sand for ECB's Jean-Claude Trichet
What's in store for the European Union in 2009?
Caius Plinius Secundus, (AD 23 – August 25, 79), better known as Pliny the Elder, was a Roman military commander and philosopher; a busy and intelligent man. His greatest legacy was one of the largest written works to have survived to the modern day in its original format: Naturalis Historia, an impressive encyclopedia of the natural world, which established the scientific standard for centuries afterward.
To this day two items from Naturalis Historia remain in our everyday lexicon: first is the quote, "True glory consists in doing what deserves to be written; in writing what deserves to be read," and second is the misrepresentation of ostriches burying their heads in the sand; Pliny the Elder actually recorded they hide their head in the bushes.
As I watch the actions of Jean-Claude Trichet, the president of the European Central Bank (ECB), I am reminded of Pliny the Elder's remarks. Despite the rapidly expanding, pan-European deflationary malaise, where the banking systems of Spain, Iceland, Ireland, Greece and Hungary are totally insolvent; where Ireland's debt-GDP ratio has skyrocketed to 80% year-over-year (with an annualized budget deficit of almost 10%); where the sovereign debts of Greece and Spain have already been downgraded and ratings warnings have been issued for several other countries; where trillions of dollars of asset values have been wiped out; where government tax revenues are in decline and rising unemployment threatens to spill into the streets – against this backdrop, Mr. Trichet was quoted as saying there is “no threat” of deflation in the euro zone.
Under the rules of the Stability pact, the EU member countries must adhere to the guidelines of an annual budget deficit no larger that 3% of GDP and an aggregate debt-GDP ratio of 60% or less. But few in Europe can boast even a positive GDP, while the acceleration of national debt is simply alarming. In the UK, bank and insurer bailouts already have a price tag of £500 billion; the British pound now sits at a 24-year low against the U.S. dollar, while net capital outflows are staggering. Banks in Spain, Switzerland and Italy have been also bailed out or nationalized, and the total costs of the euro zone crisis have yet to be fully realized.
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My only confusion is the lack of risk premium priced into current EU debt. Presently, the German 10-year bond, the European benchmark, yields 3.23%, but Spanish debt only yields an extra 113 basis points (bp). In fact, with the exceptions of Ireland, Greece, Poland and Hungary, the hopelessly indebted nations of Europe are trying to attract foreign money with investment premiums of less that 150 bp over their more secure German counterparts. At some point, investors will demand higher risk premiums, and simply tighter regulations by the ECB will not stimulate foreign capital inflows into a floundering Spanish economy, nor will they inspire the German populace to spend their national gold reserves on bailing out Hungary and Italy.
I strongly believe that further sovereign downgrades to junk or third-world status lie ahead for several European countries. What's worse, regardless of how "at the ready" Mr. Trichet is to take on the Herculean task of a pan-European reorganization, there is a very real probability of sovereign defaults in 2009. When asked about such a possibility, his response was, “I would totally exclude any kind of hypothesis such as the one you suggest.”
In response, I can only suggest revising Pliny the Elder’s quote to, “True glory consists learning what needs to be done, and saying what deserves to be said.” Mr. Trichet is now attending the World Economic Forum in Davos, where we see a fresh blanket of new snow. As much as he wishes to bury his head in the sand where sand is difficult to come by, we would be happy to deliver a bucket by overnight courier.
Adapted from an essay originally published on January 28 in Bill Fox's Interest Rates Specialty Service. (See full menu for EWI's Specialty Services.)
Bill Fox is EWI's Senior Bonds Analyst. He has been involved in the markets since graduating in 1988 from Vanderbilt University. He joined EWI in 1994; most of his subscribers are professional bond traders spread around the globe.