Cash is liquid. Lack of cash is a lack of liquidity. Hence, the PIIGS (or at least, Greece, Ireland and Portugal so far) have this problem. They’re tackling it with massive austerity programmes to try bring government revenue (taxes) to balance with expenditure (health, education, transport etc). Austerity takes time.
A key question that comes up is: What are bonds? The real question should be: how do governments borrow? How do they pay for deficits? Right now, each EZ member issues its own debt (in the form of bonds) to pay for deficits in their national accounts.
Each eurozone (EZ) member issues debt in the form of bonds. A bond isn’t a physical thing. Its an IOU. You can think of it as an embossed piece of paper with the amount borrowed written on it if you’d like with an interest rate attached i.e. ‘I, Ireland, promise to pay you €1m in 20 years at 4% interest.’
The government gets the money to use now and agrees to pay it later. It is for this reason that bonds are called ‘Treasury Bills’ or ‘Gilt-edged Securities’ because they go to pay for the running of the country and a country is hardly likely to go bankrupt like a business can.
‘The Market’
Lets use Ireland as an example. Ireland uses the euro and needs cash. Ireland issues debt in the form of a bond. What this means is that Ireland asks investors (usually banks at home and abroad) to borrow money at a certain interest rate. Like any loan, the higher the risk, the higher the bank will charge you per year in interest. At the end of a stated period (could be 2 years or 100) the investor/banks get paid the face value of the bond back. The interest is the profit on the deal.
Suppose an investor begin to reckon that his Irish bonds aren’t a great investment after all?
This could be because:
- Theres high inflation in Ireland and the value of the original bond is declining
- Theres a risk Ireland wont pay the bond (default)
You’ve probably guessed (2) is the problematic one today in the PIIGS. Investors are even faced with a slightly different version of ‘default’ called ‘debt restructuring’ which usually means investors receive a ‘haircut’ i.e. lose a high % of the initial value written on the bond.
An Investor thinks he might get stiffed. What does he do?
The bond (embossed paper remember!) doesn’t just sit in the investors drawer. He trades it with other investors on bond markets. If he thinks that suddenly the Irish bonds he owns are going to lose their value (or not be paid up), he’ll sell it!
Well, he charges a higher rate of interest. This makes it very expensive for Country A to borrow. Country A has a problem. It must borrow to pay for its mounting deficits or else it wont be able to pay any of its debts and default.
What if he still holds Irish bonds? No matter. Bondholders get paid back before shareholders do.
So, whats the deal with Eurobonds?
As one recent image from The Economist illustrated well, ‘Eurobonds’ would be issued by the eurozone-17, not single member nations.
The reason why this would be a good thing is pretty straightforward. Imagine you buy your mother a sub-par present for her birthday and want to save face by combining that gift with your brothers much better one and put both your names on the collective birthday bundle. The good balances out the bad. Yin and yang, etc. Of course, the ‘good’ in this case are the six AAA rated eurozone nations and the bad are the PIIGS. Collectively, deficit/debt problems in the EZ look reasonable. For the EZ as a whole, the Debt : GDP ratio is 88% (higher on the periphery balanced by lower levels in the core.) This compares with a level of 98% for the US, 83% for the UK. Deficit levels in the EZ-17 are 4%, far better than the US level of 10% and 8.5% for the UK.
Read the rest of this entry »
In the PIIGSty Publication on the euro, we said there are fundamental aspects to the single currency which make its collapse or break-up next to impossible. Looks like we’re not alone in that (learned) opinion! Economists at UBS have totted up the sums on the cost of a country withdrawing from the euro. It doesn’t show a pretty picture.
Posted by Editor 
piigsty 