The euro crisis may look like a tiny dot in the rear view mirror for the moment, but it could return at any time. Right now, confidence in the troubled countries is growing as the recovery continues.
Greece, which only two years ago imposed huge losses on creditors through the biggest debt restructuring on record, managed to sell five-year bonds at a yield of under 5% last month. Its ten-year government bond yields are under 10% from almost 50% in 2012.
Investors have returned to other formerly troubled countries. Italian ten-year yields have slid to a record low of just over 3%. Spain’s ten-year yield is near a euro-era low. Irish bond yields, once 10% higher than gilts, are back to virtual parity.
Portugal has just sold ten-year bonds with a yield of 3.6%. In early 2012 that yield was 17%. Lower yields mean lower long-term interest rates, which should spur investment and faster growth.
But investors are wrong to have gone “potty on the periphery”, says The Economist. The outlook is nowhere near good enough to justify the slide in yields. The main problem is that the debt-ridden countries are unlikely to recover fast enough to get their public debt mountains under control.
A country’s debt burden depends on how much it owes and the gap between the growth rate and the real (inflation-adjusted) interest rate it must pay. “On each count, Europe’s peripheral governments fare poorly.”
The debts are huge, mostly above 100% of GDP. “Structural reforms, from freeing labour markets to deregulating cosseted industries, have not been radical enough to transform their growth prospects.”
To make matters worse, prices are falling in several of the southern states. Deflation makes debt burdens heavier by increasing the real value of a fixed sum. It also raises real interest rates, making it harder to service the debt. Growth is likely to stay weak in the periphery, too weak to end deflation, which is already making the debt worse.
Investors appear to be hoping deflation will force the European Central Bank to start quantitative easing, or money printing, to combat it. But Germany, always fearful of inflation, still seems unlikely to allow it any time soon.
As the danger of a Japan-style slump grows, fears of peripheral bankruptcy, and accompanying political turmoil, could make a comeback before too long.