People are worried about the Euro. As bad news flows out of Europe – persistent unemployment, popular discontent over painful austerity measures, and catastrophic bank losses tied to still-deflating real estate markets – international investors continue to cast doubt over the Euro-Zone’s short- and long-term stability. Fear of at least a partial disintegration of the monetary union is rampant. Indeed, Morgan Stanley recently released the results of a survey of 150 of its clients; while only 3 percent of the investors thought there is more than a 60 percent chance that the Euro-zone will break up, three-quarters of the respondents thought there was some probability of a breakup. These statistics raise a double concern. First is the fear that this nightmare scenario will come to pass, an unprecedented event that could fatally wound investor confidence in the Euro, potentially eliminating its viability as a secure store of value. Second, one might fear this fear itself, as these investors’ worries might contribute to their own realization.
Financiers justify the distinctive double movement of the last several decades by arguing that markets are efficient. Neither the proliferation of capital markets nor the wearing away of regulations on them would be legitimate cause for concern if markets could be counted on to allocate capital to the areas of the economy that deserve it. Yet this period’s continual booms, busts, and crises provide a substantial and ever-increasing body of evidence that these supposedly rational capital markets are, in fact, anything but. As much as Florida’s decaying, uninhabited subdivisions attest to the dangers of irrational exuberance, Ireland’s swaths of unsold houses and imploding, too-big-to-fail banks attest to the power of expectations. They demonstrate that rather than allocating resources on the basis of soberly considered “economic fundamentals,” capital markets have a stubborn tendency to synthesize their own realities from the grist of investors’ expectations.
Consider how the now-familiar contagion of financial crisis replays itself in each of the PIIGS (Portugal, Italy, Ireland, Greece, Spain), adding to the uncertainty about the Euro-Zone’s continued solidarity. First, the hard slap of reality deflates a convenient and officially supported untruth, swamping the government’s budget with red ink. In Greece, it was Prime Minister George A. Papandreou’s acknowledgement that his predecessor had been hiding massive government obligations in complex financial instruments, cleverly designed by the whizzes at Goldman Sachs. Ireland’s difficulties stem from the painful popping of its massive real estate bubble, which hit its banking sector with losses so big they overwhelmed the Irish state’s aggressive bailout attempts. In both cases, deficits quickly piled up and investors started to worry that the governments might default on their sovereign debts.
This is when a new and dangerous set of self-reinforcing expectations took hold of the situation. To appease investors worried about the riskiness of their debts, the Greek and Irish governments were forced to raise the yields on their bonds. Perversely, increasing the price of their sovereign debt service further strained their budgets and made defaults more likely. This, in turn, made international investors more cautious about lending to these governments, necessitating further increases in bond yields. Worse, the more concerned investors become about any one of the PIIGS, the more likely it is that the contagion will spread to the other fragile countries gorging themselves at the trough of international capital markets.