As of last week, the eurozone no longer had a functioning sovereign bond market. The crisis has spread to France, whose bond spreads have approached Italian levels of six months ago. The unfortunate accident of Standard & Poor’s mistaken publication of a French ratings downgrade tells us that the rating agency is clearly preparing a downgrade. It merely pressed the button too early. The European financial stability facility, the fragile and undercapitalised construction on which Europe’s rescue strategy rests, is therefore also likely to lose its triple A rating. The prospect of a temporary return of sanity in Italian politics eased the pressure a little at the end of last week. But this does not change the depressing reality that the eurozone may be only weeks away from a financial collapse.
I am hearing from Berlin that the German government believes that the arrival of Mario Monti as Italian prime minister is all it will take to calm the markets. This unsurprisingly complacent view misjudges the underlying dynamic of the most recent events. The cause of the panic attack was the European Council’s decision on October 26 to renegotiate the private sector participation of Greek sovereign debt holders. With that decision European leaders destroyed what was left of a functioning eurozone government bond market. Investors interpreted it – correctly in my view – as a precedent. They then dumped their Portuguese, Spanish, Italian and even French government bonds. As of now, there is only one significant risk-free asset in the eurozone – German government bonds.
The German government bond market is large and liquid, but not large enough to sustain the world’s second largest economy. The presence of a risk-free asset can hardly be overstated in a modern financial system. Each insurance company, each pension fund needs to invest part of its income in such assets. Through a combination of short-sightedness and financial illiteracy, the European Council has now put itself in a position where it desperately needs Eurobonds, if only to assure the existence of a functioning financial sector.