The ‘spread’ has become something of a synonym of Europe’s debt crisis. There is barely a news program that does not mention it. It usually means disaster when it goes up and plain sailing when it goes down. But is that true? What is it anyway? And does it have any significance for our everyday life?
What has been referred to as ‘spread’ is technically the difference between the interest rate of German Bunds (German government securities) and sovereign obligations issued by other European countries. German Bunds have been picked as reference or benchmark because they are seen as quasi risk-free investments, or in other words the risk that Germany will not pay back its debts is perceived as close to zero.
Since I am living in Italy let’s take the spread between Bunds and BTPs as an example (see chart). We can see that the gap opened up until the beginning of November 2011 (max on 09/11/11 at 5.53%) decreased then somewhat and marked another top at the beginning of January 2012 (09/01/12 at 5.31%). Since then the spread came down steadily to below 3% and is now raising again. So why is that?
The spread peaked in November at the time when former prime minister Silvio Berlusconi lost entirely his grip on reality, denying the existence of any crisis in Italy and Europe. He was forced to step down however because of ongoing legal proceedings against him (for paid sex with under aged girls and the like). He was replaced by Mario Monti, a well-connected Professor of Economics with banking background who served many years as an European official in Brussels. He managed to restore confidence in Italian government policy to the point where he was seen as the saviour of Europe and its currency. The spread fell. All was well again.
Then at the beginning of January 2012 the debt crisis worsen once more. It came to a head in Greece. Greece defaulted (even though European politicians performed remarkable rhetorical gymnastics just to try to convince investors and themselves of the opposite). Spreads shot up again everywhere except Germany. The Greek tragedy got ‘solved’ and spreads came down, specially in Italy (although a huge liquidity injection into the ailing banking system by the ECB played a big part in it). But the crisis has not gone away. Now Spain is in the eye of the storm. You guessed it, spreads are raising once again.
What are we to make of this continuous up and down?
- The spread is a somehow imprecise measure whether government policy of country A is working or not, since country A is tied to country B, C and so on in a common currency regime.
- The only policy that has been tried so far (saving and austerity) does not bring spreads down conclusively since it pushes economies already in recession ever deeper into trouble, hence the risk of failing to serve debts has not decreased but will further increase, so will the spreads.
- There is no rescue without growth or at least hope of future growth. I cannot detect any policy anywhere that stimulates much-needed growth. Further job losses and further hardship are on the cards.
- In my words: The spread is an indicator for the level of stress in an economy. It is already unacceptably high and growing. But for how much longer?