Nov 28, 2011

Spain and Italy: Public finance problems.

The news of the macroeconomics of Spain and Italy (and the Eurozone) are abundant these days. These graphs show the 10 year bond yield for both countries. The large increase indicates that the bonds are perceived as riskier by investors. Investors might think that both governments have a limited capacity to pay their debts in the future. Investor might think that the governments have fundamental public finance problems, as a consequence investors demand a higher yield. 

The question is what is gonna happen next? These are some broad and extreme scenarios just to understand the situation:

1) The European Central Bank (ECB) starts buying bonds from Spain and Italy. By doing that there is an increase in the demand for bonds. An increase in the demand will increase the price of bonds, and as a consequence the yield will go down (the yield and the price of bonds move in the opposite direction). Why this could work? When the yield goes down some expect that investor will gain confidence again and would perceive the bonds as less risky, and they will maintain their positions. Why this could not work? If the public finance problems of these countries are very serious, the buying of bonds from the ECB will have no effect or very limited effect in bringing tranquility to investors, who in spite of the actions of the ECB, would keep selling their bonds or/and demanding higher yields. 

1) The European Central Bank does nothing. Investors might become very nervous and might start selling their bonds, as a consequence the yield will continue increasing, reflecting higher and higher risk. The problem with this is that eventually investors will not want to hold any debt from these countries, as a consequence the governments will have lower income. This implies that their public services and social spending will suffer, which could bring social unrest. And this will reduce further foreign direct investment. 

Some are even saying that this might bring the braking up of the Eurozone:
The banking sector, too, is broken. Important parts of the eurozone economy are cut off from credit. The eurozone is now subject to a run by global investors, and a quiet bank run among its citizens.
This massive erosion of trust has also destroyed the main plank of the rescue strategy. The European Financial Stability Facility derives its firepower from the guarantees of its shareholders. As the crisis has spread to France, Belgium, the Netherlands and Austria, the EFSF itself is affected by the contagious spread of the disease. Unless something very drastic happens, the eurozone could break up very soon.
As in many of these cases the root of the problem is the bad health of public finances, but it can get more complicated than that. 

You can read different perspectives on this issue, one here, another here, another here., and here
Source of graphs. 

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