The markets are demanding more answers

11.04.12 Publication:

If you believe the financial markets, the difference between happy recovery and imminent disaster is 80,000 American jobs, in a country with a labour force of 155 million people, plus admittedly some mildly negative news from China. Of course this cannot be true, especially not from a European point of view. Still, the post-Easter scare in the markets does remind us of something that really is true.

It is a mistake to pay too much attention, beyond amused admiration or horror, to daily or even weekly movements in equity, bond or currency markets. The reason is simple. It is that the art of financial trading has nothing to do with identifying genuine economic trends.

That art has everything to do with identifying the psychology of the herd of animals that is a good approximation for financial traders. To make money, you have to guess correctly which way the herd is going to run. What happens the day or week or month after your trade is of no interest at all.

So a sudden fall in equities or rise in bond spreads does not mean that anything substantial has changed in the world economy. The US economy seemed to be having moderate growth, of perhaps 2-2.5% a year, even before the jobs numbers for March produced a small disappointment. The Chinese economy too was slowing down, before the slightly disappointing news there about inflation and manufacturing orders.

Yet underneath all this, and underneath the nervous behaviour of European bond and equity markets, does lie a fundamental truth. It is that neither the sovereign-debt problems of the eurozone as a whole, nor those of Italy in particular, have been solved. And every new piece of data about eurozone growth and unemployment is currently suggesting that the recession in the euro area, and especially in southern Europe, is getting worse.

The sovereign-debt crisis is half about simple arithmetic and half about political will. The simple arithmetic says that if Spain’s and Italy’s economies suffer a deeper recession this year than they forecast only a couple of months ago, then either or both will miss their targets for reducing their government budget deficits. This would mean that if President Monti is serious about sticking to the European fiscal compact he signed in December, he would need to bring in another set of budgetary manoeuvres, of tax rises and spending cuts.

My bet is that this is likely to happen: that he will have to break his pledge that there would be no further budget cuts this year. That is where the political will comes in. The markets, which means people buying and selling government bonds, have to place a bet on whether Spain and Italy will do what it takes to meet their eurozone commitments, or not. Taken in isolation, naturally it is clear that President Monti does indeed have this political will. But he cannot be taken in isolation.

The initial big political questions overshadowing the markets come from other countries. Certainly from Greece, where opinion polls suggest that the main winners in the parliamentary elections on May 6th will be small, anti-reform and anti-austerity parties. But also from France, where a victory for the socialist Francois Hollande in the second round of the presidential elections on that same day could destabilize the eurozone’s fiscal treaty.

But the political questions also lie in Italy. As President Monti knows very well, his reform achievements during his four months in office look remarkable only in comparison with those of the three governments that came before him. They are not remarkable in comparison with the size of the task.

He has achieved an important, but modest, liberalization programme, a small boost to competition enforcement, and—if it does pass into law—an important but also not dramatic reform to the labour laws. No buyer of Italian government bonds can have concluded that Italy’s prospects for economic growth have thereby been transformed.

The fall in Italian bond yields owed something to the Monti government’s credibility and reforms, but much more to the massive subsidy from the European Central Bank, in the form of cheap three-year loans to European banks, which has persuaded banks, especially Italian ones, to hold more Italian debt.

So it should surprise no one that bad economic news has persuaded financial traders to bet that the bond-market herd might run against Italy. That was a good and easy short-term bet.

The question is whether it might also become a good long-term bet. The answer to that will lie in the depth of Italy’s recession, on the political waves that emerge from Greece and France, on the ability of the Monti government to push through further reforms, and, ultimately, on whether this period of reform can be expected to last. If it is believed to be just, at most, a one-year phenomenon, a transition between the old politics and more old politics, then there can be no doubt: the herd will stampede.