To bond or not to bond?

I picked up and read this paper over at P. Krugman’s blog (The spanish prisoner). Mighty interesting stuff and simple like your basic school arithmetic. The main point of the paper is the contradiction observed when comparing the debt and borrowing interest of Spain with that of the UK (Spain issues its debt in the currency of a monetary union i.e. a currency they don’t control and the UK issues its debt in a currency they control). The contradiction is this:

While the UK debt as a percentage of GDP is higher than that of Spain the borrowing rates are paradoxically higher for Spain than the UK. This means markets consider Spain a more likely candidate for default than the UK!

So what kind of data do the markets use to draw such a conclusion? Why don’t they do the fundamental arithmetic and treat the country with the lower debt as more trustworthy? The explanation according to the paper lies in the fact that Spain is in the euro zone and the UK is not. If investors thought (and wanted to act on that belief) that the UK is about to default then they would sell UK bonds (driving interest rates up) but they would get UK pounds in return. If they wanted to get rid of their pounds they would a. have to find buyers and b. be confronted with possible unilateral devaluation. This would leave the money in the UK economy to refinance an economic recovery. What happens in the case of Spain? Well if investors start believing that Spain will default then they start selling Spanish bonds and they get Euros in return. This drives the interest rates high (i.e. borrowing is more expensive for Spain) but (unlike in the case of the UK) investors pocket their euros and invest them elsewhere (say in German bonds). The euro zone makes it easier to dry up peripheral economies and drive them to default.

So rising borrowing costs for the periphery go hand in hand with lower borrowing costs for the core. The latter are unwilling to keep on saving the periphery which can only bleed so long before it erupts. On way out would be to put euro bonds on the table around which sit smart, reasonable people instead of populists. In any case the dilemma is clear for Europe: Integrate or disintegrate in other words do or die.

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