Thursday, September 22, 2011

Germany is a Credit Risk?

Maybe this will spur politicians in Germany to take more decisive steps to deal with the eurozone debt crisis: today the spreads on credit default swaps (CDS) - those derivatives that effectively provide insurance against default - rose by 8% today on German government bonds. Anyone who wanted to insure their German bonds against default today had to pay over 100 basis points for the first time ever. That's the same as it cost to insure French government bonds less than 3 months ago, or Italian government bonds about 6 months ago. This week marks the first time that such insurance costs signifcantly more for German bonds than for those of the UK.

But the principal lesson that I draw from this is not that the risk of Germany defaulting on its debt has risen recently. Is Germany really that much more likely that the US or the UK to default? If we take a deep breath and think clearly about things, I doubt that many people would answer yes to that question.

Rather, I take this as a sign that investors are panicking, and panicking specifically about anything having to do with the eurozone. It may not be rational, but a pervasive and ill-defined fear is gripping the financial markets right now. In the current context, that is what contagion is all about.

There are certainly plenty of things for people to worry about right now, of course: stagnating recoveries in the developed world; political brinksmanship and paralysis in the US; endless indecision in Europe regarding how to help the struggling periphery economies; financial institutions that seem weak, opaque, and untrustworthy; slowing growth in China.

All of these factors are certainly contributing to the deep anxiety that currently grips financial markets. But I think that this is evidence that of all of these, the fear of what will happen in Europe looms largest. Which brings me to my own fear: that time is running out for the eurozone to take steps to get the market's fear under control and avert catastrophe.


  1. techer2:44 AM

    Breakup of eurozone would be more traumatic for Germany than UK or US. If the currency revalaution really hits German GDP by 20%, as some have estimated, Germany's debt to GDP ratios and expected trajectories can easily become worse than for US and UK.

  2. kharris8:49 AM

    CDS prices, like any other, reflect the intersection of the views of buyers and sellers. Even if German prospects had stayed the same, a reluctance to absorb risk on the part of the CDS seller would push up German CDS costs.  Obviously, the fundamental background for increased risk aversion hurts German prospects, but it's hard to tease apart shifts and supply and demand in the CDS market, to know how much the perception of German risk has risen.

  3. Robert Graham11:40 AM

    I came to your site following a reference from Paul Krugman.  I enjoy macroeconomics, especially when it is backed up with relevent statistics.  I wonder if you think we have a fiscal crisis or an unemployment crisis or both in the U.S.  What is amazing to me is the stability of the dollar despite monetary policy being zero-bound in comparison with other so-called "safe" countries.  Even the relative decline of the dollar and the negative interest on treasuries considering inflation have not curbed the appetite for treasuries  When you write about contagion, are you predicting a worldwide depression, or do you think this will remain somewhat localized?

  4. Ken Houghton2:05 PM

    "Is Germany really that much more likely that the US or the UK to default? If we take a deep breath and think clearly about things, I doubt that many people would answer yes to that question."

    Depends how deep the breath is.  techer gets half of it: a breakup of the Eurozone has a direct impact on German GDP, much moreso than US or UK.  The other half is: What if the Eurozone doesn't break up?

    1) More bad money after good (de facto country-but-not-EUR-currency devaluation, if you prefer) followed by (2) enough loans going bad/"restructuring" so that the ones that are related to them have to be remarked as well, followed by (3) a cycle of (1) and (2) until you finally reach default.

    Short version of the long view: the Swiss just ****ed the Germans by pegging to the EUR, and the alternatives only get worse going forward due to bad German bank lending having started and accelerated the whole thing.

    The default risk of the three countries is (1) US cannot "extend and pretend" the mortgage mess and/or Bachmann-Perry Overdrive takes over, (2) UK continues austerity and theirs is a race between currency and credit ratings to see which is too devalued too quickly, and (3) the Germans keep doing and saying what they have been doing and saying, while declaring that their own malfeasances are non-existent.

    That's what I see when I take a deep breath. Two primarily-political problems and one that is fundamentally financial/economic and being exacerbated by politics.  If I were forced to play a trifecta--or put on a butterfly option--I would have to think and work very hard to avoid concluding that Germany was the greatest risk of the three countries.

    CDS trading, after all, is not so much "risk that the country will default" as it is "risk that the probability that the country will default gets worse."  As kharris noted, "the perception of German risk has risen." And I don't see anything on the horizon to make me believe it will get better sooner than the US or the UK.

    The Swiss took care of that.

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