When governments run deficits, these must be financed by borrowing. The main form of borrowing is government bonds. To persuade people (mainly private-sector institutions, such as pension funds) to buy these bonds, an interest rate must be offered. Bonds are issued for a fixed period of time and at maturity are paid back at face value to the holders. Thus new bonds are issued not just to cover current deficits but also to replace bonds that are maturing. The shorter the average term on existing government bonds, the greater the amount of bonds that will need replacing in any one year.
In normal times, bonds are seen as a totally safe asset to hold. On maturity, the government would buy back the bond from the current holder at the full face value.
In normal times, interest rates on new bonds reflect market interest rates with no added risk premium. The interest rate (or ‘coupon’) on a bond is fixed with respect to its face value for the life of the bond. In other words, a bond with a face value of £100 and an annual payment to the holder of £6 would be paying an interest rate of 6% on the face value.
As far as existing bonds are concerned, these can be sold on the secondary market and the price at which they are sold reflects current interest rates. If, for example, the current interest rate falls to 3%, then the market price of a £100 bond with a 6% coupon will rise to £200, since £6 per year on £200 is 3% – the current market rate of interest. The annual return on the current market price is known as the ‘yield’ (3% in our example). The yield will reflect current market rates of interest.
These, however, are not ‘normal’ times. Bonds issued by many countries are no longer seen as a totally safe form of investment.
Over the past few months, worries have grown about the sustainability of the debts of many eurozone countries. Bailouts have had to be granted to Greece, Ireland and Portugal; in return they have been required to adopt tough austerity measures; the European bailout fund is being increased; various European banks are having to increase their capital to shield them against possible losses from haircuts and defaults (see Saving the eurozone? Saving the world? (Part B)). But the key worry at present is what is happening to bond markets.
Bond yields for those countries deemed to be at risk of default have been rising dramatically. Italian bond yields are now over 7% – the rate generally considered to be unsustainable. And it’s not just Italy. Bond rates have been rising across the eurozone, even for the bonds of countries previously considered totally safe, such as Germany and Austria. And the effect is self reinforcing. As the interest rates on new bonds are driven up by the market, so this is taken as a sign of the countries’ weakness and hence investors require even higher rates to persuade them to buy more bonds, further undermining confidence and further driving up rates.
So what is to be done? Well, part of the problem is that the eurozone does not issue eurobonds. There is a single currency, but no single fiscal policy. There have thus been calls for the eurozone to issue eurobonds. These, it is argued would be much easier to sell on the market. What is more, the ECB could then buy up such bonds as necessary as part of a quantitative easing programme. At present the ECB does not act as lender of last resort to governments; at most it has been buying up some existing bonds of Italy, Spain, etc. in the secondary markets in an attempt to dampen interest rate rises.
The articles below examine some of the proposals.
What is clear is that politicians all over the world are trying to do things that will appease the bond market. They are increasingly feeling that their hands are tied: that they mustn’t do anything that will spook the markets.
Articles
Bond market hammers Italy, Spain ponders outside help Reuters, Barry Moody and Elisabeth O’Leary (25/11/11)
German Bonds Fall Prey to Contagion; Italian, Spanish Debt Drops Bloomberg Businessweek, Paul Dobson and Anchalee Worrachate (26/11/11)
Rates on Italian bonds soar, raising fears of contagion Deutsche Welle, Spencer Kimball (25/11/11)
Brussels unveils euro bond plans Euronews (23/11/11)
Germany faces more pressure to back eurobonds Euronews on YouTube (24/11/11)
Bond markets Q&A: will the moneymen hit the panic button? Guardian, Jill Treanor and Patrick Collinson (7/11/11)
Why we all get burnt in the bonfire of the bond markets Observer, Heather Stewart, Simon Goodley and Katie Allen (20/11/11)
Retaining the confidence of the bond market is the key to Britain’s success in the EU treaty renegotiations The Telegraph, Toby Young (19/11/11)
Boom-year debts could bust us BBC News, Robert Peston (25/11/11)
UK’s debts ‘biggest in the world’ BBC News, Robert Peston (21/11/11)
Markets and the euro ‘end game’ BBC News, Stephanie Flanders (24/11/11)
The tricky path toward greater fiscal integration The Economist, H.G. (27/10/11)
The tricky path toward greater fiscal integration, take two The Economist, H.G. (23/11/11) and Comments by muellbauer
Data
European Economy, Statistical Annex Economic and Financial Affairs DG (Autumn 2011) (see Tables 76–78)
Monthly Bulletin ECB (November 2011) (see section 2.4)
Bonds and rates Financial Times
UK Gilt Market UK Debt Management Office
Questions
- Explain the relationship between bond yields and (a) bond prices; (b) interest rates generally.
- Using the data sources above, find the current deficit and debt levels of Italy, Spain, Germany, the UK, the USA and Japan. How do eurozone debts and deficits compare with those of other developed countries?
- Explain the various proposals considered in the articles for issuing eurobonds.
- To what extent do the proposals involve a moral hazard and how could eurobond schemes be designed to minimise this problem?
- Examine German objections to the issue of eurobonds.
- Does the global power of bond markets prevent countries (including non-eurozone ones, such as the UK and USA) from using fiscal policy to avert the slide back into recession?
UK unemployment is rising. According to figures released by the Office for National Statistics, in the third quarter of 2011 the unemployment rate was 8.3%, the highest since 1986. The number unemployed was 2.62 million, up 129,000 on the previous quarter.
The figures for those aged from 16 to 24 are particularly worrying. If you include those in full-time education but who are looking for employment and are available for work, the unemployment rate in this age group was 23.3%. If you exclude those in full-time education, the rate was 20.6% (up 1.8 percentage points since the previous quarter).
The government was quick to blame the eurozone crisis for the rise in unemployment. The Minister of State for Employment, Chris Grayling, said, “What we are seeing are the consequences of the crisis in the eurozone.”
But is this true? Unemployment is a lagging indicator. In other words, it takes time for unemployment to respond to changing economic circumstances. Thus the rise in unemployment from quarter 2 to quarter 3 2011 was the result of the economic conditions at the beginning of 2011 and earlier – a time when growth in the eurozone was faster than that in the UK. The eurozone economy grew by 2.4% in the 12 months to 2011Q1, whereas the UK economy grew by only 1.6% over the same period. Even taking the 12 months up to 2011Q3, the eurozone economy grew by 1.4%, whereas the UK economy grew by only 0.5%.
Of course, if the crisis in the eurozone leads to another recession, then this will almost certainly lead to a rise in unemployment. But that’s to come, not what’s happened.
The following articles look at the rise in unemployment and especially that of young people. They examine its causes and consider possible solutions at a time when governments in the UK and around the world are concerned to reduce public-sector deficits and debt.
Articles
Youth unemployment breaks 1m mark Independent, Alan Jones (16/11/11)
UK unemployment increases to 2.62m BBC News (16/11/11)
Youth unemployment reaches 1986 levels The Telegraph, Donna Bowater (16/11/11)
Over a million young people are jobless BBC News, Hugh Pym (16/11/11)
Unemployment figures rise ‘related to eurozone crisis’ BBC News, Employment minister Chris Grayling (16/11/11)
Labour’s Liam Byrne: Young jobless paying ‘brutal price’ BBC News, Shadow Secretary for Work and Pensions Liam Byrne (16/11/11)
UK unemployment ‘nothing to do with eurozone’ BBC News, Lord Oakeshott (16/11/11)
Coalition sheds crocodile tears over young jobless Guardian, Larry Elliott (16/11/11)
Is youth unemployment really rising because of the eurozone crisis? Guardian, Polly Curtis (16/11/11)
Eurozone and the UK: A tale of two crises BBC News, Stephanie Flanders (15/11/11)
Data
Latest on the labour market – November 2011 ONS on YouTube (16/10/11)
Labour Market Statistics, November 2011 ONS (16/10/11)
Harmonised unemployment levels and rates for OECD countries (annual, quarterly and monthly) OECD StatExtracts
Economic Data freely available online Economics Network
Questions
- What are the causes of the UK’s rise in unemployment in quarter 3 of 2011?
- Why is unemployment particularly high for the 16 to 24 year old age group?
- Find out the unemployment rates for the 16 to 24 age group for other European countries for both females and males. How does the UK rate compare with the rest of Europe?
- What are meant by a ‘lagging indicator’ and a ‘leading indicator’? Why is unemployment a lagging indicator?
- Identify some other lagging indicators and some leading indicators and explain why they lag or lead the level of economic activity.
- What solutions are there to high unemployment of young people (a) in the short run; (b) in the long run?
With all the concerns recently about Greek and Italian debt and about the whole future of the eurozone, you would be forgiven for thinking that the problems of the UK economy had gone away. This couldn’t be further from the truth. Problems are mounting and pessimism is growing.
First there is the problem of a contracting eurozone economy. This will directly impact on the UK as almost half of UK exports go to eurozone countries. Second there is the impact of the government expenditure cuts, most of which have still not taken effect yet. Third there is the fact that, with the combination of inflation over 5% and nominal pay typically rising by no more than 2%, real take-home pay is falling and hence too is the volume of consumer expenditure. Fourth, there is the increasingly pessimistic mood of consumers and business. The more pessimistic people become about the prospects for their jobs and incomes, the more people will rein in their spending; the more pessimistic businesses become, the more they will cut back on investment and economise on stock holding.
Forecasts for the UK economy have become considerably bleaker over the past few weeks. These include forecasts by the National Institute for Economic and Social Research (NIESR), the accountancy network BDO, Ernst & Young’s ITEM Club and the CBI in its SME Trends Survey and November Economic Forecast. The Treasury’s latest Forecasts for the UK Economy, which brings together forecasts by 29 different organisations, also shows a marked increase in pessimism from September to October.
So is it now time for the government to change course to prevent the economy slipping back into recession? Do we need a Plan B? Certainly, it’s something we’ve considered before on this news site (see Time for a Plan B?). The latest call has come from a group of 100 leading academic economists who have written to the Observer. In their letter they spell out what such a plan should contain. You’ll find a link to the letter below and to other articles considering the proposals.
The letter
We economists have a Plan B that will work, Mr Osborne Observer letters (29/10/11)
Articles
Plan B: the ideas designed to restart a stalled UK economy Observer, Daniel Boffey and Heather Stewart (29/10/11)
Plan B could have been even more aggressive, but it would definitely work Observer, Will Hutton (29/10/11)
The economy: we need Plan B and we need it now Observer editorial (30/10/11)
If tomorrow’s growth figures disappoint, Plan B will be a step closer, whatever David Cameron says The Telegraph, Daniel Knowles (31/10/11)
Plan B to escape the mess we are in Compass, John Weeks (7/11/11)
The report
Plan B; a good economy for a good society Compass, Edited by Howard Reed and Neal Lawson (31/10/11)
Questions
- What are the main proposals in Compass’s Plan B?
- How practical are these proposals?
- Without a Plan B, what is likely to happen to the UK economy over (a) the coming 12 months; (b) the next 3 years?
- Why might sticking to Plan A worsen the public-sector deficit – at least in the short term?
- What are the main arguments for sticking to Plan A and not easing up on deficit reduction?
- Find out what proportion of the UK’s debt is owed to non-UK residents? (See data published by the UK’s Debt Management Office (DMO).) How does this proportion and the average length of UK debt affect the arguments about the sustainability of this level of debt and the ease of servicing it?
- If you had to devise a Plan B, what would it look like and why? To what extent would it differ from Compass’s Plan B and from George Osborne’s “Plan A”?
Well they say that a day is a long-time in politics – that an awful lot can happen within 24 hours. The two days of the G20 summit have seemed like a lifetime. The meeting took place in Cannes from 3 to 4 November, 2011. It was the sixth such meeting of the G20: the 19 largest developed and developing countries plus the European Union.
As chair of the meeting, President Sarkozy of France had planned to address the two key global issues of securing a sustained global recovery and strengthening the global banking system. He also wanted to address other issues, such as climate change, commodity price volatility, social inclusion, corruption and corporate governance. But although these issues are covered in the final communiqué, what took centre-stage for the whole summit was the crisis in Greece and its impact on the eurozone.
The drama began on Monday 31 October. The Greek Prime Minister, George Papandreou, decided to call a referendum on the agreement reached at the eurozone summit in Brussels the previous week. In return for banks being required to take a loss of 50% in converting existing Greek bonds into new ones, Greece would have to continue with its tough austerity measures: measures that have caused the Greek economy to implode.
With worries that (a) the referendum would create several weeks of uncertainty, (b) that the agreement might then be rejected, (c) that the government might fall, stock markets plunged. French and German markets fell by over 5%. The Athens stock market fell by 7 per cent. The yield on Italian bonds passed 6%, amidst fears that if Greece defaulted, so too might Italy. But if the eurozone could survive a Greek default, it might not survive an Italian one. Even though several members of Mr. Papandreou’s Pasok party demanded his resignation, he stuck to his guns that an agreement had to have the consent of the Greek people. That was Tuesday.
The next day, Wednesday, was the start of the two-day G20 conference. What was to have been a meeting addressing wider issues of the global economy, was now having to focus on the Greek crisis. President Sarkozy and Chancellor Merkel made it clear that the next tranche of bailout money to Greece would not be paid until the deal agreed in Brussels was accepted by Greece. They gave the first indications that they might accept Greece’s withdrawal from the eurozone.
On Thursday afternoon, Mr Papandreou signalled that he would back down from the referendum if the opposition New Democracy party would join him in supporting the Brussels deal. He would not resign. But the opposition leader, Antonis Samaras, said that his party would not join with Mr Papandreou and that the Prime Minister should indeed resign. He did not resign, but abandoned the calll for a referendum.
With the Greek crisis dominating the meeting, little concrete agreement was reached. One important outcome, however, was the recognition that the financing of the IMF should be strengthened. As the final communiqué states:
We will ensure the IMF continues to have resources to play its systemic role to the benefit of its whole membership, building on the substantial resources we have already mobilized since London in 2009. We stand ready to ensure additional resources could be mobilised in a timely manner and ask our finance ministers by their next meeting to work on deploying a range of various options including bilateral contributions to the IMF, SDRs, and voluntary contributions to an IMF special structure such as an administered account. We will expeditiously implement in full the 2010 quota and governance reform of the IMF.
But despite this recognition of the key role of the IMF, the agreement was essentially that an agreement would be needed!
Articles
Eurozone crisis: yet another twist to Greek farce keeps leaders on edge of seats The Telegraph (4/11/11)
G20 summit: the main issues at Cannes The Telegraph (3/11/11)
Quick! More sandbags (filled with cash) The Economist, Charlemagne’s notebook (4/11/11)
The burning fuse The Economist, Charlemagne’s notebook (4/11/11)
G20 leaders agree to boost IMF resources BBC News (4/11/11)
G20 summit fails to allay world recession fears Guardian, Patrick Wintour and Larry Elliott (4/11/11)
G20 summit: roll call of doom for a dysfunctional family Guardian, Angelique Chrisafis (3/11/11)
Euro zone finds no new money for debt crisis at G20 The Economic Times of India (4/11/11)
Shares jump after referendum ditched New Zealand Herald (5/11/11)
Bunds rise on EFSF worries, Italy under pressure Reuters (4/11/11)
Eurozone crisis: The possible resolutions BBC News (4/11/11)
The G20 aren’t running to Europe’s rescue BBC News blogs, Stephanie Flanders (4/11/11)
Is the euro about to capsize? BBC News, Laurence Knight (4/11/11)
Final Communiqué
Meeting of Finance Ministers and Central Bank Governors: final communiqué G20–G8 France 2011 (4/11/11)
Questions
- Why might the ‘game’ between the eurozone leaders and George Papandreou be seen as a prisoner’s dilemma game? What are the payoffs?
- Why might increasing the bailout for Greece represent a moral hazard for the eurozone leaders?
- Trace through market reactions between the 31 October and the 4 November and explain the movements.
- How crucial is the IMF in achieving global stability and economic growth?
- Assess the success of the Cannes G20 conference.
At its meeting on 26 October, the eurozone countries agreed on a deal to tackle the three problems identified in Part A of this blog:
1. Making the Greek debt burden sustainable
2. Increasing the size of the eurozone bailout fund to persuade markets that there would be sufficient funding to support other eurozone countries which were having difficulties in servicing their debt.
3. Recapitalising various European banks to shield them against possible losses from haircuts and defaults.
The following were agreed:
1. Banks would be required to take a loss of 50% in converting existing Greek bonds into new ones. This swap will take place in January 2012. Note that Greek debt to other countries and the ECB would be unaffected and thus total Greek debt would be cut by considerably less than 50%.
2. The bailout fund (EFSF) would increase to between €1 trillion and €1.4 trillion, although this would be achieved not by direct contributions by Member States or the ECB, but by encouraging non-eurozone countries (such as China, Russia, India and Brazil) to buy eurozone debt in return for risk insurance. These purchases would the form the base on which the size of the fund could be multiplied (leveraged). There would also be backing from the IMF. Details would be firmed up in November.
3. Recapitalising various European banks to shield them against possible losses from haircuts and defaults. About 70 banks will be required to raise an additional €106.4 billion by increasing their Tier 1 capital ratio by 9% by June 2012 (this compares with the Basel III requirement of 6% Tier 1 by 2015).
On the longer-term issue of closer fiscal union, the agreement was in favour of achieving this, along with tight constraints on the levels of government deficits and debt – a return to something akin to the Stability and Growth Pact.
On the issue of economic growth, whilst constraining sovereign debt may be an important element of a long-term growth strategy, the agreement has not got to grips with the short-term problem of a lack of aggregate demand – unless, of course, the relief in markets at seeing a solution to the debt problem may boost business and consumer confidence. This, in turn, may provide the boost to aggregate demand that has been sadly lacking over the past few months.
Certainly if the reaction of stock markets around the world are anything to go by, the recovery in confidence may be under way. The day following the agreement, the German stock market index, the Dax, rose by 6.3% and the French Cac index rose by 5.4%.
Articles
Eurozone crisis explained BBC News (27/10/11)
Leaders agree eurozone debt plan in Brussels BBC News, Matthew Price (27/10/11)
Eurozone agreement – the detail BBC News, Hugh Pym (27/10/11)
10 key questions on the eurozone bailout Citywire Money, Caelainn Barr (27/10/11)
European debt crisis: ‘Europe is going to have a very tough winter’ – video analysis Guardian, Larry Elliott (27/10/11)
Eurozone crisis: banks agree 50% reduction on Greece’s debt Guardian, David Gow (27/10/11)
The euro deal: No big bazooka The Economist (29/10/11)
Europe’s rescue plan The Economist (29/10/11)
European banks given just eight months to raise €106bn The Telegraph, Louise Armitstead (26/10/11)
EU reaches agreement on Greek bonds Financial Times, Peter Spiegel, Stanley Pignal and Alex Barker (27/10/11)
Unlike politicians, the markets are seeing sense Independent, Hamish McRae (27/10/11)
Market view: Eurozone rescue deal buys time FT Adviser, Michael Trudeau (27/10/11)
Greece vows to build on EU deal, people sceptical Reuters, Renee Maltezou and Daniel Flynn (27/10/11)
Markets boosted by eurozone deal Independent, Peter Cripps, Jamie Grierson (27/10/11)
Has Germany been prudent or short-sighted? BBC News blogs, Robert Peston (27/10/11)
Germany’s Fiscal union with a capital F BBC News blogs, Stephanie Flanders (27/10/11)
Questions
- What are the key features of the deal reached in Brussels on 26 October?
- What details still need to be worked out?
- How will the EFSF be boosted some 4 or 5 times without extra contributions fron eurozone governments?
- Why, if banks are to take a 50% haircut on their holdings of Greek debt, will Greek debt fall only to 120% per cent by 2020 from just over 160% currently?
- On balance, is this a good deal?