James Carville, an advisor to former President Clinton, is famous for saying :
"I used to think that if there was reincarnation, I wanted to come back as the president or the pope. But now I would like to come back as the bond market. You can intimidate everybody.
" This year, Europe has discovered how right Carville was. The bond markets decided that the public finances of Greece, Ireland and now Portugal are not sustainable. The result was a prohibitive rise in the interest premium demanded by the market for their government bond issues, resulting in an inability to refinance current spending and expiring debt. This forced their governments into drastic and previously unthinkable austerity measures, and drove the creation of an EU bail-out fund to avoid the case of sovereign default of a Euro-country, a huge embarrassment with financial and political implications for the entire Eurozone. But the power of the bond markets went much beyond Greece and Ireland, and even beyond other countries of "peripheral Europe" with similar problems. Almost all countries in Europe, including apparently healthy ones such as Germany, Luxembourg and others, have recognised that the bond markets are now closely scrutinising public finances making real distinctions between them, and pricing in corresponding interest rate premiums. And we are now seeing with Ireland, once the markets refuse to refinance, they are in the position to dictate the type and extent of austerity that is required. Furthermore, the country can be subjected to pressure from its EU bailout partners - the best example being the insistence by France and Germany that Ireland should now also increase its corporate tax rate from the current 12,5% - a crass and disgraceful attempt to link EU bailout money to what these two countries consider "unfair" Irish tax competition.
A country that no longer has control over its tax and spending policy has lost important dimensions of its sovereignty. Luc Frieden, Luxembourg's finance minister, is on record as saying that Luxembourg's would lose its fiscal sovereignty should its accumulated debt reach 30% of GDP from its current level of roughly 15%. Since the Greek crisis, almost all countries in Europe, including those outside the Eurozone, have woken up to the danger of an adverse bond market judgments and the loss of sovereignty that this threatens. After record public deficits in 2009 to replace failing private demand in the wake of the financial crisis, governments everywhere have performed a sharp about-turn: although growth remains fragile, they are implementing more or less drastic austerity programmes, with the express purpose of reducing accumulated government debt. They are thus making a clear choice - satisfying the bond markets - over other policy objectives such as employment. One of the most visible of these was the UK's recent budget, where the government is reducing spending by 25% and eliminating 500 000 public sector jobs.
Governments are right to make such choices. As we have seen twice this year, once the markets have rendered a judgment, it is too late. Governments are dependent on market refinancing in the immediate term; by contrast, political lead times for implementing austerity measures are longer. And for many reasons, market-forced austerity and bailouts are never the best solution. They are politically difficult in the concerned country, and, in the case of bailouts, in the countries providing the bailout funds. As they are drastic, they represent a shock to the economy that creates far more disruption and costs to individuals and businesses than a pre-emptive programme implemented earlier, gradually, in measured doses. Far worse, they create a situation of confrontation between the markets and the street, as we are witnessing with the strikes in Greece. These seem manageable in this case; it is far from sure that this will always be the case. There is also much potential for populist politicians to exploit such situations.
The bond markets will be scrutinising European public finances even more intensely in the future. Under the changes to the Lisbon Treaty proposed by Germany and agreed to in principle by all other EU countries, bond holders will be required to bear a part of any future bailout costs after 2013. The proposals are sensible. Without a free ride in the form of automatic tax payer bailouts, the markets will be forced to make judgments and give signals on the public finances of bond-issuing governments much more carefully and much earlier. This will provide a much stronger market mechanism for ensuring that governments maintain sound fiscal policy: through much earlier interest rate signals, the markets will punish profligate governments and reward those pursuing sustainable policies. Recent austerity measures have mostly focussed on reducing spending. But ultimately, sustainable public finances will be determined by the revenues generated by sound economic fundamentals, in particular competitiveness in world markets. Wealth and related tax revenues are ultimately generated by competitive industries. This will be the main challenge for countries whose problem is declining competitiveness.
James Carville was right; bond markets can intimidate powerful governments. But bond markets are essential for government to fulfil its role in society. They allow society to redistribute the burden of public finance across generations, to make public investments before these provide a return, to finance emergency spending. In short, they are essential for nations to fully exercise their sovereignty. The bond markets are governments' friend, not its enemy. It is up to governments to keep their houses in order to be able to make best use of them.
" This year, Europe has discovered how right Carville was. The bond markets decided that the public finances of Greece, Ireland and now Portugal are not sustainable. The result was a prohibitive rise in the interest premium demanded by the market for their government bond issues, resulting in an inability to refinance current spending and expiring debt. This forced their governments into drastic and previously unthinkable austerity measures, and drove the creation of an EU bail-out fund to avoid the case of sovereign default of a Euro-country, a huge embarrassment with financial and political implications for the entire Eurozone. But the power of the bond markets went much beyond Greece and Ireland, and even beyond other countries of "peripheral Europe" with similar problems. Almost all countries in Europe, including apparently healthy ones such as Germany, Luxembourg and others, have recognised that the bond markets are now closely scrutinising public finances making real distinctions between them, and pricing in corresponding interest rate premiums. And we are now seeing with Ireland, once the markets refuse to refinance, they are in the position to dictate the type and extent of austerity that is required. Furthermore, the country can be subjected to pressure from its EU bailout partners - the best example being the insistence by France and Germany that Ireland should now also increase its corporate tax rate from the current 12,5% - a crass and disgraceful attempt to link EU bailout money to what these two countries consider "unfair" Irish tax competition.
A country that no longer has control over its tax and spending policy has lost important dimensions of its sovereignty. Luc Frieden, Luxembourg's finance minister, is on record as saying that Luxembourg's would lose its fiscal sovereignty should its accumulated debt reach 30% of GDP from its current level of roughly 15%. Since the Greek crisis, almost all countries in Europe, including those outside the Eurozone, have woken up to the danger of an adverse bond market judgments and the loss of sovereignty that this threatens. After record public deficits in 2009 to replace failing private demand in the wake of the financial crisis, governments everywhere have performed a sharp about-turn: although growth remains fragile, they are implementing more or less drastic austerity programmes, with the express purpose of reducing accumulated government debt. They are thus making a clear choice - satisfying the bond markets - over other policy objectives such as employment. One of the most visible of these was the UK's recent budget, where the government is reducing spending by 25% and eliminating 500 000 public sector jobs.
Governments are right to make such choices. As we have seen twice this year, once the markets have rendered a judgment, it is too late. Governments are dependent on market refinancing in the immediate term; by contrast, political lead times for implementing austerity measures are longer. And for many reasons, market-forced austerity and bailouts are never the best solution. They are politically difficult in the concerned country, and, in the case of bailouts, in the countries providing the bailout funds. As they are drastic, they represent a shock to the economy that creates far more disruption and costs to individuals and businesses than a pre-emptive programme implemented earlier, gradually, in measured doses. Far worse, they create a situation of confrontation between the markets and the street, as we are witnessing with the strikes in Greece. These seem manageable in this case; it is far from sure that this will always be the case. There is also much potential for populist politicians to exploit such situations.
The bond markets will be scrutinising European public finances even more intensely in the future. Under the changes to the Lisbon Treaty proposed by Germany and agreed to in principle by all other EU countries, bond holders will be required to bear a part of any future bailout costs after 2013. The proposals are sensible. Without a free ride in the form of automatic tax payer bailouts, the markets will be forced to make judgments and give signals on the public finances of bond-issuing governments much more carefully and much earlier. This will provide a much stronger market mechanism for ensuring that governments maintain sound fiscal policy: through much earlier interest rate signals, the markets will punish profligate governments and reward those pursuing sustainable policies. Recent austerity measures have mostly focussed on reducing spending. But ultimately, sustainable public finances will be determined by the revenues generated by sound economic fundamentals, in particular competitiveness in world markets. Wealth and related tax revenues are ultimately generated by competitive industries. This will be the main challenge for countries whose problem is declining competitiveness.
James Carville was right; bond markets can intimidate powerful governments. But bond markets are essential for government to fulfil its role in society. They allow society to redistribute the burden of public finance across generations, to make public investments before these provide a return, to finance emergency spending. In short, they are essential for nations to fully exercise their sovereignty. The bond markets are governments' friend, not its enemy. It is up to governments to keep their houses in order to be able to make best use of them.
