Will Eurozone be able to repay its debts? Is a bubble forming there?

European Council – March 2015 (Day 2). In the forefront, from left to right: Matteo Renzi, Italian Prime Minister, Alexis Tsipras, Greek Prime Minister, Francois Hollande, President of France. (European Council – Council of the European Union, Audiovisual Services, Shoot location: Brussels – Belgium, Shoot date: 20/03/2015).

This newspaper has been very reluctant in endorsing the widely accepted view that Eurozone has left behind its stagnation if not recession phase. The reason is that despite the GDP increases by a few decimal points – not more than three – of a percentage unit, inflation kept falling for more than twelve months until it reached its lowest level at -0.6% last January. After January however the consumer prices index keeps rising albeit remaining in the negative part of the chart reaching -0.3% in February and -0.1% in March. If it crosses to the positive area in April, the upwards tendency may be considered as established. Let’s see what more there is to it.

During the past few months developments regarding headline inflation rates were not the only indication that something may be changing towards the right direction in Eurozone. The overall industrial production index in comparison to the same period of previous year kept rising continuously during the six months up to February 2015. Of course this positive build up is restricted to some decimal points every month. Nonetheless, it represents a firm trend in the right direction.

It’s the €60 billion stupid

However, if it were not for the €60 billion that the European Central Bank spends every month since last March to buy government bonds and asset backed securities, this newspaper would have repudiated all the above mentioned petite positive developments as non-essential. Thanks to ECB’s pledge to circulate newly printed money of €1.14tn until September 2016 in monthly installments of €60bn, Eurozone may finally overcome its stagnation and enter a new growth period, most probably of uncertain vitality. This new money bonanza though had another much more visible result, sending Eurozone government debt prices to new highs and depressing debt yields close to or below zero. In reality this is money for free.

Money for free

It’s a fact now that around one-quarter of Eurozone’s government debt pays negative yields, meaning that investors are currently accepting to lose some money, in order to acquire bonds of that kind. Of course those who bought similar paper in 2014 or earlier are making hefty capital gains. On the contrary, Eurozone government bond paper yields negative returns for those who bought it during the past few weeks. In total the Eurozone government debt has reached now €8tn; that is 92% of GDP.

And don’t you think that it’s only Germany that can issue government debt with negative yields. The Austrian, the Dutch, the Irish and even the French short-term debt paper is traded at negative returns. It was even more surprising to have watched Spain on Tuesday 7 April selling six month government bills of a total value of €750 million at a yield of -0.002%. Even Portugal can place in the capital markets government bonds offering close to zero returns. Of course Greece is in the opposite side of the market, with its ten-year bonds trading at yields around 13%.

Is there a bubble?

Understandably, some economists may call those developments in the Eurozone debt market, a bubble. But bubbles always occur and the problem is how they deflate without ruining a lot of people. In this respect growth will play a central role. Eurozone’s real economy seems now able to start growing again, helped by the ECB’s €1.14 trillion. At the same time, this kind of money has inflated the demand for European debt and will continue doing so. In reality the sings of a bubble are already there and the question is if growth is also dawning.

There is one critical condition though for these two parallel developments to move towards the desirable direction, and this is no other than the degree of prudency that Eurozone’s political elite can show. If they start behaving like the new Greek government, which strongly favors consumption over production, then the bubble will soon burst. However, if the European politicians manage to avoid populism and wisely use the new abilities that the zero cost financing from the ECB offers, then there will be no sudden bubble bursting and a gradual deflation of the public debt balloon may evolve quietly over the next many years.

Can Germany alone do it?

Germany, the largest Eurozone economy together with Holland and Austria are already applying prudent policies. That given, it becomes clear that everything depends on France, Italy and Spain the second, third and fourth largest Eurozone economies. If those major countries manage to take full advantage of ECB’s new money bonanza in order to enter a solid growth path and at the same time secure their ability to repay their debts, Eurozone will have no problem whatsoever.

In short, investing today in Eurozone’s government debt is like investing on its political elite’s ability to wisely steer the economy. Eurostat’s indicators do not yet confirm a solid upwards trend. Not to forget that a Grexit or a Brexit may dangerously perplex all that.

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