January 18, 2011

Debt death spiral

Issuing debt when you have problems is not the answer. It is not the answer for today's problems and obviously it will not be the answer for your forthcoming problems... In fact it creates more problems for the future. Take the case of a struggling household, what is the wise thing to do if your income was to decrease for some reason: Keeping your spending as usual by borrowing money? or trying to optimize it and reduce expendables? Everyone on its right mind will tell you the later is the only responsible and logic way to go. Well, everyone but European governments or so it seems.

As seen in a previous post, stopping government spending overnight would not help the economic recovery at all, but when you are struggling to move forward you simply cannot keep borrowing to insanely high rates of 5 to 8% for your 10 year bonds. Truism: 10 years later you have to pay them back... Governments usually have 4-year terms, so they are genuinely short-sighted in their own interest. This makes issuing debt an easy way of putting problems under the carpet. Just let the next government find the solution.
A responsible government should rationalize their debt issuing, specially when dealing with high rates, limiting it to just the essentials. You can think about raising your debt again when the macro circumstances are better, but for now just hold tight to what you have and make the most of it. 

What we have seen lately in Europe is some government's inability to see this. They have been naive enough as to think the markets would forget about their current economic situation when placing more debt. The markets did not fall for that, and so asked for a higher yield to buy said bonds. 

Death spiral
Europe has already had the cruel example of Greece (Bloomberg Chart for its 10yr bond, actually at 11%), a country whose sovereign debt rose above 12% before collapsing; and the less cruel but not less important example of Ireland (Bloomberg Chart for its 10yr bond, actually at almost 9%). Portugal seems to come next with an already unbearable 7% (Bloomberg Chart for its 10yr bond) yield which puts them into a scarily similar position to Greece before its collapse. 

By having a quick look at the respective charts it is easy to trace the similarity between them. When a troubled country's bonds reach above the 7% mark the country is essentially done. It becomes a lifeless toy in the hands of the markets which mercilessly put the country in the dark, cold, waiting room for an European Union rescue package.

Meanwhile Spain, Belgium and Italy are looking at the issue from an uncomfortably near distance and they seems to be the following prey of avid speculators. If one of these later countries were to follow the path of Greece, Ireland and Portugal the European Union could be in serious trouble. A sense of responsibility must appear on these countries governments to avoid this fearful situation and it has to appear as soon as possible. It is late but not too late to do things right.

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