Almost a week after the French and Greek elections, Europe plods on. This may come as a surprise to the doomsayers who assumed the arrival of François Hollande as France's new socialist president would instantly shred the Franco-German alliance that allegedly kept the euro zone from shattering. It hasn't and it won't.
Greece, to be sure, is a mess – political gridlock on an epic, even comical, scale. So what? Last Sunday's election confirmed what everyone knows: Its exodus from the euro zone is rapidly going from the possible to the probable. Out with the new, in with the old. The drachma is almost certainly coming back.
So can investors stop fretting about the election results? Depends which kind of investors.
Mr. Hollande's message that an endless budgetary slice-and-dice operation offers no cure for ailing economies is, broadly speaking, good news. His insistence that a growth pact be run alongside austerity is hardly dangerous economic theory. Austerity heaped on to a deepening recession – the 17-country euro zone is shrinking again – ranks somewhere between reckless and insane. But since any growth policies will take time work, the markets will take some time to react.
Sovereign-bond investors face a different story, for two reasons. The first is the risk of renewed contagion from a country barrelling ever faster toward the euro zone exit doors as anti-austerity parties surge in popularity.
The second is that bond investors have emerged as soft targets in the great European restructuring game.
Greece, with ungentle nudging of the so-called troika – the European Union, the European Central Bank and the International Monetary Fund – managed to reduce its national debt burden by about €110-billion ($142-billion) in February. It did so by slicing the net present value of the bonds held by private investors (largely banks) by 70 per cent.
The effort succeeded with minimal disruption. While the experience wasn't pleasant for the bond holders, the markets, the euro and the banks did not collapse. It had to be done. The alternative would have been forcing another €110-billion in spending cuts and tax hikes onto a country with 22-per-cent unemployment (and 54-per-cent youth unemployment). Greece would have been bled white.
The question now is whether the Greek bond "haircut" will be repeated elsewhere in the euro zone. Why wouldn't it?
Assume that Mr. Hollande's emphasis on growth, which has already received qualified support from Italy's Mario Monti, the ECB's Mario Draghi and Germany's Angela Merkel herself, will only produce results down the road, perhaps way down the road. In the meantime, Ireland, Portugal, Italy, Spain, even France, are swirling down the economic toilet and need help. Sadly, the options are hardly lavish.
Governments in those countries are tapped out as the jobless rate rises, growth vanishes and income tax receipts shrink. The ECB, Teutonic to the bone, has signalled that it is running out of room to manoeuvre. It has flooded €1-trillion of liquidity into the banks through the LTRO – long-term refinancing operation – since late last year. It shows no willingness to ramp up its purchases of sovereign bonds even though there is close to zero evidence that such purchases are inflationary. When it buys the bonds, the ECB is buying on the secondary market, that is, it's merely shifting the bonds from investors' balance sheet to its own.
More austerity is not an option. Austerity worked in Canada in the 1990s, when Canadian and U.S. economies were leveraging up and expanding. It's not working in Europe, when spending cuts and tax hikes are coming as households and businesses are de-leveraging. When everyone is saving to pay off debt – surprise! – economies go into reverse.
The new European rescue fund, meanwhile, remains a work in progress. It's not nearly big enough to rescue Italy or Spain, the euro zone's third- and fourth-largest economies, if they get shut out of the debt markets.
That leaves Greek-style bond haircuts. When plans were revealed last year to send owners of Greek debt to the barbershop, the troika made it clear that Greece was a one-off event – the haircut would not be repeated elsewhere in the euro zone. Trouble is, no one believed it and bond yields in the clapped-out countries duly soared, some to crisis levels. In Italy, bond yields went so high that prime minister Silvio Berlusconi found himself out of a job and was replaced by Mr. Monti's technocrat government.
Bond yields have come off their peaks, but they're rising again, notably in Spain. On Friday, yields on Spanish 10-year bonds climbed above 6 per cent, putting them close to crisis levels. Italian yields rose to 5.7 per cent. They had been as low as 5 per cent not long ago.
You could blame the deepening Spanish recession and the country's banking mess for the rising Spanish yields. You could also assume that Spanish bonds are not immune to haircuts. Just because the troika said the Greek bond restructuring will not be cloned elsewhere does not mean it won't happen. Clobbering bond holders elsewhere in the euro zone is not out of the question as the debt crisis, after a brief interlude, gallops forward. Bond buyers beware.
Eric Reguly