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LOTS OF SILLY NOTIONS get pounded into our brains while we are young and impressionable. In your first macroeconomics course, the concepts of fiscal and monetary policy were introduced, perhaps as two separate levers the government manipulates to guide the economy on a steady, tranquil path to full employment and stable prices. That no such perfect state of being ever existed did not intrude into the theory being propounded to a bunch of slack-jawed freshmen.
Yet, there remains a notion that sound monetary policy is necessarily associated with sound fiscal policy. It seems logical the two virtues should go together. As the old Sammy Cahn-Jimmy Van Heusen song, "Love and Marriage," goes, "You can't have one without the other."
Or can you? Consider the heresy of the opposite: that sound money can lead to fiscal excesses; that low and stable inflation encourages lenders to provide credit on increasingly generous terms. Borrowers, of course, take advantage of lenders' overconfidence and ultimately get too deep into hock. Why? Because they could.
Such musings are brought to the surface by the deepening crisis in Greece's debt market, which saw yields shoot higher again Thursday. Yields on 10-year Greek government bonds soared 40 basis points (0.4 percentage points), to 7.15%, nearly twice that of benchmark German bunds. That's significant because both Greek and German bonds are denominated in euros and therefore have the same currency risk.
The difference in yields reflects the market's assessment of the Athens government's ability or willingness to pay its debts. On that score, the cost to insure Greek government debt for five years jumped nearly 13% Thursday, to 422,490 euros per 10 million euros principal amount, according to CMA Datavision, a unit of CME group that tracks credit-default swaps.
Greece appeared to have stabilized its listing fiscal ship earlier in the week with the (apparently) successful sale of 8 billion euros of bonds. But, according to one well-placed market source, the demand for the Greek bonds mainly represented buying at depressed prices by hedge funds -- to cover previous short sales. With that source of buying sated, the downward spiral of the Greek fiscal crisis continues.
Which comes back to the question of how the crisis came about. Let me proffer a hypothesis about the euro: the adoption of the common currency across the Continent (and Ireland) was an attempt to gain the advantages of the strong German deutschemark.
Italy, for instance, was able to go from high interest rates resulting from the unstable lira to low German rates. In the run-up to the adoption of the euro in 1999, fortunes were made in the "convergence trade," in which hedge funds would borrow deutschemarks at low interest rates to buy high-yielding Italian or Spanish bonds, whose yields would necessarily fall close to those of German bunds.
That arbitrage exists to this day. The U.K. and Ireland hold about 23% of outstanding Greek debt, the Financial Times reports, followed by France with 11% and 6% in Italy. Germany, Austria and Switzerland hold about 9% while the Benelux countries own another 6%. They all believe they are getting nearly risk-free high yields because Greek debt is denominated in sound euros.
This notion that governments are creditworthy because the currency in which they borrow is sound is analogous to handing a credit card to a teenager. Your probity has resulted in a generous credit line that, because of your prudence, you rarely tap, and then pay off quickly. An adolescent may have a rather different attitude.
A nation's adoption of the cloak of a foreign currency to gain credibility and thus, credit, wasn't confined to Europe. From 1991 to 2002, Argentina pegged its peso to the dollar through a currency board. That meant Argentines could freely exchange their currency for dollars at a 1:1 ratio. With the threat of constant devaluation and hyperinflation seemingly eliminated, Argentina went on a credit binge. By 2001, Argentina abrogated the peg and the convertibility, and it takes nearly 4 pesos to buy a greenback.
Americans should not look condescendingly at these instances. Since inflation was conquered in the early 1980s, the nation's borrowing binge took off. During the bad old days of the 1970s and the early 1980s, cash would yield as much as 20%, so banks had little incentive to extend loans. When cash yields began to plummet, they moved increasingly aggressively to gain assets that provided decent yields. That, in turn, brought down interest rates for everybody resulting in the binge for which we are paying dearly now.
Ultimately, these fiscal excesses tend to be the undoing of the sound money that aided and abetted them in first place. What's different this time is that the currency of the biggest debtor, the U.S., is more apt to rise as the problems of the likes of Greece deepen.
Comments: randall.forsyth@barrons.com
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