Part 4: Waking Up to the Great Shocks

May 8, 2012
Presentation (.pdf)

Several “great shocks” in 2009 and 2010 woke up the financial markets to the risk of default on European sovereign debt, Waller says. This led to increased interest rates because financial markets no longer viewed Italian, Greek, Irish, Portuguese and Spanish debt as close substitutes for German bonds.


Christopher Waller: Everybody, it was a big party, it was the euro, everybody's happy. Let's just bring them all in and, oh, yeah, the Greeks are going to have this thing called the Olympics in 2004, maybe it's not a bad idea to let them in.

All right. So after joining the monetary union, as I showed you, if I extended that graph, Greece paid effectively the same interest rate on their debt as Germany, the best performing country, despite what I just showed you was a very weak fiscal condition. So your first thought should be, all this fiscal stuff looks very, very dangerous or a concern, and yet they're paying the same rate of interest as the Germans. So what happened? I'm going to call these the great shocks. In the summer of 2009, a new Greek government came in. By the way, they just got kicked out. But they came into power, and when they took power, the previous government had claimed that Greece's deficit-to-GDP ratio was just under 4 percent. A little high for the criteria but not too far. The new government came in, opened up the books, looked at what happened, and found out it was actually 16 percent.

Now, we were all pretty sure that the Greeks were kind of lying about things. We never thought they were lying that bad. Okay? So at the same time roughly, Ireland in the first financial crisis in 2007 and '08 had to bail out their banking system. The Irish stepped in and said they'll protect everything in the Irish banking system, and that put enormous cost on the Irish government to the point of driving the government into default. So to give you an idea, through the 80s and 90s, Ireland was the darling of Europe, the Celtic tiger. Their economic performance and growth was phenomenal. By 2007 at the start of the first financial crisis, their debt-to-GDP was 25 percent, under 25 percent. And its deficit, zero. I mean, that's fiscal performance. Three years later their debt-to-GDP was over 100 percent and their deficit-to-GDP was 30 percent. This is why bailing out banks in a financial crisis can be very expensive.

Now, these two shocks in these two small countries in Europe at the same time kind of woke up the markets that, "holy smokes, these countries are not Germany." It's a bit of a mystery what they were thinking. So here's just some pictures—every now and then you've got to throw in some graphs instead of words. But you can see as 2008 the crisis, all these countries start running up large—This is Ireland. As I said, they were down to around 25, now they're up at over about 100. Every one of them—Italy, of course was already over 100. Really nothing changes. It goes up a little bit. Italy wasn't, like, sitting out there. And that picture looks like that if I go all the way back to 1990. I mean, Italy's just plunking along, 100 percent, no big movements over a decade. There's Greece, you know, 100 up to about 160.

So all of a sudden after these, what I'm going to call the great shocks, financial markets no longer looked at Italian, Greek, Portuguese, Irish and Spanish debt to be close substitutes for German debt. People kind of disparagingly referred to these countries as the PIGS. I'm going to be a little more politically nice and call them the GIPS. So immediately what happened was markets started saying "whoa, whoa, whoa, whoa, I don't know about this rollover thing. This rollover thing is not looking like such a good bet anymore." So if you want me to rollover your debt, I want a higher interest rate because now I'm worried you're not going to pay this off.

Between January of 2008, January 2012, the spreads between German debt and Greek debt increased by 3,300 basis points. 100 basis points is 1 percentage point. So that's 33 percentage points. Now, we're not talking about going from two to six, we're going from two to 35. That's what you get if you go to a loan shark. So this is basically what we see. These are the spreads between these countries' debt at 10 years' maturity to the Germans. And you can see basically it was zero for Portugal, and now it's about 10 full or 13 full percentage points. There's Spain, again, near zero. Now it's up around 350 basis points. Ireland, you can see the big run-up and then a drop down. I'll talk about that in a second, why this drop down has occurred. Same thing with Italy. They're all the same, they're all the same, and now Italy in 2011 has seen this run-up.

I'm going to show you one slide. I had to put Greece on a separate slide because the scale, I couldn't fit it on that thing so I just had to put it on a separate slide. Again, here's the Greek debt. In '07 it's basically equivalent. Now it's, well, as of today or close to today it's about 3,500 basis points above German debt.