The Destabilizing Stabilization Mechanism?

Is the new European Stability Mechanism behind the price plunge of Spanish sovereign debt?

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The Financial Times blog Alphaville, which has been covering the mechanics of the European debt crisis in great detail has raised just that question. And they have provided a link to a very ugly looking curvethat shows the yield of Spanish sovereign debt spiking.

Alphaville cites Harvinder Singh of Royal Bank of Scotland:

"We expected a relief rally—even if the only relatively safe place was seen as the short end of rescued countries such as Ireland—but in the event the market has moved very quickly to the title of the research note: European periphery crisis: no turning point in sight yet. The spread widening after the initial tightening should frighten policymakers. Make no mistake this is a crisis of EMU."

And the cause of the 'crisis'? "The market assessment is that the new policy structures, now with a relatively trivial watering down of the private sector restructuring risk, makes little sense."

If there was any lingering doubt about where Mr. Singh stood on the issue, he goes on to make it clear: "The market is correct. This is the Merkel crash we have been outlining."

Alphaville also links to another of their articles on the 'reflexivity' of Irish bonds, where Economist Paul de Grauwe, of Leuven University essentially makes the case against bondholders taking haircuts on sovereign debt.

De Grauwe lays out a plausible sounding case for why this is so.

Essentially, when bondholders begin to see ominous signs for the sovereign debt they hold looming on the horizon, they will begin unloading that debt, because of the fear of getting haircut. This of course will exacerbate downward price pressure on the bonds and create a positive feedback loop—or downward spiral—for the sovereign debt of the country in question.

In the words of Economist Paul de Grauwe:

"First, as the perceived risk of these bonds will increase, the interest rate on these bonds is likely to go up. This is the effect that has been stressed by the President of the European Central Bank, Jean- Claude Trichet. Defenders of the sovereign default mechanism counter this argument by claiming that such a system also gives the national governments stronger incentives to maintain discipline in budgetary matters. The recent increases in the government bond spreads since the announcement of the sovereign debt default mechanism seem to vindicate Trichet."

"The second problem, however, is much more serious. This is the ERM problem, which will also become the problem of the eurozone. When governments solemnly declare that in times of payment difficulties they will devalue the government bonds (that’s what a haircut means), this will introduce the speculative dynamics in the eurozone that destroyed the ERM. Once investors expect payment difficulties of a particular government, they will sell the bonds, thereby raising the interest rate on these bonds. This is exactly what speculators in the ERM did when they expected a devaluation of the currency: they sold the currency."

De Grauwe's ultimate prediction is rather dire: "Thus, one should expect that the introduction of a sovereign debt default mechanism will make debt crises in the eurozone more frequent and more lethal.

Whether the eurozone can survive such a structural increase in the frequency and intensity of debt crises remains to be seen. I suspect that, if applied, the sovereign debt default mechanism will destabilise the eurozone and ensure its demise."

Mr. Singh is not so fatalistic about the European sovereign debt situation to suggest the probability of outright dissolution. But he isn't that far off: "So is this the end of EMU? No—but the key point is that the problems need to hit Germany before more viable solutions such as more fiscal and political integration look likely. That is, it may take a near death experience for the periphery and core EMU banking systems before this realisation dawns. At that juncture, it is possible to see some form of quasi fiscal union via a common EMU bond."

(When the range of editorial commentary spans between the outright death of a thing at its core on the one hand, and on the other a description of the 'near death experience for the periphery' it's probably not a ringing endorsement of entity in discussion's overall health. And The Financial Times is not generally held to be a gloom and doom kind of publication.)

Sing does have some comments that might be construed, on a relative basis, as positive news for the United States and, perhaps, for Britain: "The only hiding place in Treasuries and to a lesser extent Gilts"


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