The Government Bubble Pops (updated)

Events in the Eurozone are unfolding at a more rapid pace than ever, with even the normally staid Economist warning that the Eurozone might break up, with “horrible” consequences. Indeed, while a Greek default might not spell disaster for global finance and might not even require Greece’s exit from the euro, Italy is the third-largest sovereign debtor in the world. Interest rates on Italy’s ten-year debt have leaped past thresholds some economists consider “unsustainable.”

Arguably, Italy is, unlike Greece, not insolvent, merely illiquid. It enjoys a primary surplus (revenues minus non-interest expenditures). The problem is that interest-rate rises themselves will push Italy into bankruptcy, as it cannot afford to float new debt to pay off old debt. From one perspective, Italy is suffering from (irrational?) investor contagion, a speculative attack based on a self-fulfilling prophecy. Another point of view is that investors are rationally anticipating an ECB “firehose to the Italian treasury.” The firehose, of course, is merely default in another form – but it may allow Italy stay in the Eurozone and keep European taxpayers off the hook (even as consumers get the shaft).

Furthermore, the Italian crisis came about principally because the Greek crisis has forced investors to update their expectations of sovereign defaults in the OECD. Until quite recently, it was commonly assumed that OECD governments don’t “hard default” and increasingly rarely “soft default” through monetization. For instance, most political economy work on the OECD has assumed that fiscal expansions – under independent central banks – drive currency appreciation! (Even before the crisis, that may have been wrong.) EMU only fortified this assumption. What we’re seeing is the gradual popping of the “government bubble,” as investors realize that rich-world sovereign debt is not the safe haven they assumed.

What about the U.S.? Treasury yields remain at near-record lows. By 2020, U.S. debt-to-GDP will surpass 120%, according to the IMF. That’s where Italy is now. Of course, Japan sits at 220, a massive outlier, and it’s never faced default. But during Japan’s Lost Decade, real yields on Japanese bonds were reasonably high due to deflation. Moreover, expectations of future growth were higher than current growth. That’s reversed for Italy – and arguably the United States. Falling growth means falling revenues and rising pressure on the debt.

Whether U.S. government debt is experiencing a bubble right now is anyone’s guess, but it’s odd for those who fault financial market irrationalities to hold up low Treasury yields as an indication that the U.S. debt situation is sustainable.

UPDATE: See Per Kurowski and this NYT story for more on how the government bubble was inflated.

5 thoughts on “The Government Bubble Pops (updated)

  1. That is now but the whole situation is the self-fulfilling results of giving incentives to the banks to go excessively where officially the risks are considered almost non-existent like triple-A rated securities Greece or Berlusconi’s Italy.

    I invite you to read… Who did the eurozone in? and there you will understand that in this case it was indeed the butlers.

    1. Yes, that’s a very good point. The risk of contagion from PIIGS debt would be far less had bank regulators not rated these bonds so high. Of course, the banks themselves must take some responsibility as well for taking advantage of the leeway regulators gave them. They could have stuck with bigger, more reliable assets as reserves whatever the regulators allowed them.

      1. “They could have stuck with bigger, more reliable assets as reserves whatever the regulators allowed them”

        Like who? In my mind they should have stuck with small businesses and entrepreneurs like the ones the regulators did NOT allowed them to do

      2. Good point. But the banks didn’t have to go for Greek debt; they could have gone for German or U.S. The regulators let them make mistakes, but they didn’t force them to (with the exception you point out).

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