Don’t overrate the good news

In Spain, the carry trade seems to be operating (FT):

However, the success of recent Spanish government bond auctions has raised eyebrows. Spain sold €5.64bn of three-month debt on Tuesday, with the yield paid to investors falling to 1.735 per cent, down from the 5.11 per cent seen in a similar auction last month. Brokers say smaller Spanish banks may be loading up on bills to use as collateral at the ECB operations.

But don’t be too happy, here is from Jed Graham:

Much discussion — and possibly today’s stock market rally — has centered on the notion that the European Central Bank’s new policy of providing ultralow-interest, 3-year financing to banks can serve as a backdoor bailout of over-indebted sovereigns.

But don’t get too excited. This bazooka is actually a bulldozer. Rather than having the potential to flatten sovereign debt problems, it can only make them pile up into an untenable mountain — with far too much maturing within the 3-year life of the ECB program.

…Note that today’s [yesterday’s] Spanish debt sale comprised 3-month and 6-month bills.

As Reuters pointed out, Spain, unlike Italy, has relatively little debt to roll over before April. Thus, the 3-month and likely even the 6-month bills carry little risk.

But as Spain issues more short-term debt to meet new borrowing needs and to roll over maturing debt, the ECB’s backyard bulldozer is bound to produce a growing mountain of short-term funding needs.

Perhaps if Spain’s oversubscribed sale on Tuesday were for 5- or 10-year debt, one might make a case that the ECB policy was a real game-changer. But banks are unlikely to risk damaging their own credibility with investors by loading up on longer-term issuance of at-risk sovereigns.

Here is more.  The optimal policy here of course is time inconsistent. Lend out all the money and somehow forget to ask for it back, but don’t make that clear up front.  On a related note, another possible approach to the eurozone crisis is to have the United States guarantee all (non-Greek) eurozone debt, but if those countries can’t pay up simply void the guarantee, claim Berlusconi or someone blackmailed the U.S. government, and reaffirm the commitment to U.S. Treasury securities.  The market might just believe us.


The US position is simple: Just have Obama guarantee eurozone debt, the elect Ron Paul and have him say no way in hell are we giving any money to Europe. Problem solved

That was one of my first thoughts after reading that big banks would stay away from this carry-trade. Smaller banks are much more likely to be influenced by politicians and much less accountable towards investors who would want them to shy away from short-term public debt.
If Spain is interested in another buyer, I'm always open towards a banking licence!

Seems counterintuitive. Smaller banks presumably have fewer investors, which means the average investor has more power over bank decisions. Am I wrong?

According to the 'fundamentals (including the capacity to tax the rich)', Spain and even Italy are in much better fiscal state than the UK and the USA. The real problems for these countries are the high interest rates, made in Frankfurt.

Please explain. Spain can't sell its overvalued housing stock like the U.S. can sell Boeing planes to Malaysia.

These really aren't "carry trades." We call these trades "circle jerks."

Another "Anglo-Saxon" trying to talk down the 21st century United States of Europe again.


There seems to be a pervasive line of thinking that goes something like "it won't matter in 4 years, because by then all this pain will be behind us and we'll be growing again."

These people have clearly not read TGS.

Merijn K. makes an important point. Olivier Blanchard has recently posted about multiple equilibria, with the variation due to varying expectations of self-fulfilling collapses. This highlights the degree to which the currently high interest rates in the eurozone are puffed up with expectations about collapse that are not consistent at all with the underlying fundamentals of the supposedly key collapse countries, who would be Spain and Italy. In all the media hysteria endlessly repeated about them ("they are about to default! eeeeek!"), one almost never hears the caveat about how their underlying budget balances are really pretty good (and Tyler somehow never seems to mention this either, playing into all this horse manure hysteria, very popular here in the US where many commentators from many sides have always wanted a euro collapse, see Marty Feldstein to Paul Krugman).

Tall Dave,

TGS does not mean absence of growth. It means a slower growth rate than seen in the past, but still positive in the long run. Next year does not look all that great, but there is every reason to expect an increase in the growth rate sometime after that, even if it does not go back to what we saw in the late 1990s.

Italy's current budget is okay, their demographics and GDP trend augur a very bad future. Markets are concerned with the future repayment of debt.

TGS suggests declining average growth. Kicking the can down the road is not a winning strategy in those circumstances.

Tall Dave,
One does not repay debt. One rolls it over. Italy has had a high debt/GDP ratio for decades, with a much higher proportion of its debt domestically held. Italians have a high savings rate and do a lot of their saving in the form of purchasing their own country's securities. There is no evidence that is likely to change, and given that there primary budget is in surplus, there is no reason to expect an explosion of the debt/GDP ratio, even with very slow growth, unless they are pummeled with super high interest rates, which can become the self-fulfilling prophecy without a foundation.

So how does this rolling-over thing work? Does the new debt issuances repay previous issuances? Say it ain't so!

What happens, while you are being all technical, if no-one wants a given tranche? Does that leave you with matured debt and no money? What do we call this phenomen?

I think we call it default.

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