To Solve This Crisis, Just Take a Deep Breath and Calm Down

Things are evolving so quickly in the Eurozone that I’m sure this will be out of date as soon as I write it.  Or maybe not.  This is more a general thought about the crisis than a particular focus on one part.  Greece and Italy now have new governments, which I have mixed feelings about.  I don’t particularly feel that markets should be in a position to demand new governments.  In doing so, they are usurping the rights of citizens to determine their governments.  And for all that, there still seems to be no solution to this Euro Mess.  And honestly, my opinion is that a lot of it comes down to the fact that investors are panicky.  The way the bond markets are shifting focus to one country as soon as the last one they were worried about makes some progress reminds me of investor behavior at the height of the panic in 2008, when even healthy investment banks were squeezed for capital because investors didn’t feel any of them were safe.  Such all out panic risks punishing even responsible firms and governments.  The bond markets need to calm down and realize that their panic could result in the very thing they are busy panicking about.  I’ve written about the risk of self-fulfilling prophecies harming the Eurozone for almost 2 years now, and it still seems to be a problem.

Investors really should be ashamed of panicking so easily.  Many of the countries they are worried about (Portugal, Ireland, and Spain, to name a few) will be fine as long as markets remain calm.  Allowing panic to raise the interest rates on bonds risks making countries that are merely illiquid fall into full insolvency.  This is exactly what happened on Wall Street in 2008.  Investor panic shifted from one firm to the next as solutions were devised for each one.  And it would play out the same each time.  The firm’s stock would plummet, repo and overnight funding would demand more and more collateral, and they would find themselves sliding from illiquidity into insolvency, at which point they would panic themselves as they tried to find a buyer.  Only countries can’t go find themselves a buyer, which means they would have no recourse but default and bankruptcy, with all the horrific implications that go with them.  That shouldn’t have to happen.

Investors need to pause, take a deep breath, and remember the role they play in these countries’ finances.  To lower their debt, countries need stable bond markets, because the solutions to debt problems lie in the medium- to long-term, not the short-term.  Short-term volatility is causing dangerous cuts to programs that are not in these countries’ best interests.  The European periphery needs to spread out their cuts instead of adopting full austerity measures.  This is because debt reduction must be balanced against the needs of the countries’ citizens.  One reason that the Greeks rioted over the austerity measures is because it cut many services they felt entitled to, and gave them no say in the matter.  In effect, markets held the Greek and Italian governments hostage until they got what they wanted.  Such actions by the market completely overruled the desires of citizens in democratic countries, which I find completely unacceptable.  Instead, governments need to take an honest look at their finances and put matters before the people.  A referendum like the one Greece proposed that so rattled markets should have been the first move these democratic countries made.  And investors should have respected the divide between the market and the government to allow the people to express their desires.  Instead, panic has removed 2 leaders from office.  They probably should have gone anyway, but it should have been the Greek and Italian citizens who made that call, not the markets.  Of course, no government likes having such conversations with their population, but they need to happen.  Delaying them only makes them worse.

In their panic, investors are causing the very thing they fear.  They need to recognize how influential their actions  are and act like responsible adults.  Yes, some good, definitive action from the ECB, like the kind outlined by Free Exchange earlier this week, would (one would hope) calm the markets down.  I still hold out some little sliver of home that the ECB will do just such a thing.  But ultimately, investors need to get a hold of themselves and remind each other that they could, through sheer stupidity and panic, ruin themselves and several countries, all because they got carried away and couldn’t calm down.