Over the last few days I have had a few discussions about the latest attempt to 'fix the Euro'.
Let's see what happened: All European countries, except for the British, agreed to restrict how much public (government) debt they are allowed to add to their existing debt in the future. That surely is good news for the debt crisis, isn't it?
After all the debt crisis means that some investors have doubts about some European countries and the probability that they will pay back their debt in the future. Why would these investors be opposed to an agreement that said that the debtors do not want to issue much more debt in the future?
Well, if things would only be so simple.
Right now the US is able to issue 30 year debt at about 3% interest rate. That means that the US promises that it will give you back all your money in 30 years plus 3% per year if you give them some of your money now.
At the same time the inflation indexed 30-year debt has a 2% interest rate. That means that if you give the US money right now they promise to give it back in 30 years in addition to a 2% annual interest and also make sure you won't suffer from inflation. Consequently investors seem to think that the average inflation in the US for the next 30 years is going to be about 1%.
These are the historical inflation rates in the US. Apparently a grand new time has dawned.
On the other hand .. isn't the FED printing money like crazy since 2008 to prevent a credit crunch and other nasty things?
Ask any investor on the planet whether the average inflation rate in the US over the next 30 years will be 1% and he will consider you stupid. Significant inflation (maybe after some period of deflation) is highly probable in the US - and all over the world - at this point in time; and most every investor agrees.
So what the hell happens? Well, irrational markets happen and that is neither new nor necessarily a big problem. How many investors, do you think, who buy 30-year bonds today, intent to hold them for 30 years? How many of the people who bought Yahoo shares in 1999 intended to hold them indefinitely? When I buy shares, do I think that when I die they will have been worth it?
No. In fact, I have no idea. I never even thought about that. I don't intend to hold any shares or bonds that I buy today for any significant amount of time. I'm pretty sure that among global warming, peak oil, wars, and generally unpredictable events, some stuff will happen in the coming 30 years.
Google has said explicitly that they do not intend to pay dividends in the foreseeable future. Yet, you can give them your money and many people do. Why? Because they think that other people think that other people think ... that other people think that the shares might rise.
In the perfect rational market the story would be this: The guy who buys the 30-year bond after 29 years will not do this if he thinks that he will make a loss. That's why he will force the seller to agree on a price that includes all what he thinks will happen during the 30th year.
The guy who intends to buy the 30-year bond after 28 years and will sell it after 29 years (one year later) will consider this and therefore also consider the whole next two years when he makes the decision to buy something.
The guy who intends to buy the 30-year bond after 27 years ...
This whole process works about as well as Chinese whispers.
In reality I don't care so much about the future if the other investors don't. And the other investors don't care so much about the future if they don't think that the other investors do. And so on.
The reason the investors are reluctant to buy European bonds right now - except for German ones - is not that they think that Europe might go broke. Instead, they think that other people might think that other people might think that ... other people might think that Europe might go broke - or at least act like it.
Are German shares a good investment if you think that France will go broke? Of course not. That would be a global catastrophe. You'd be much better off buying weapons and storing them under your bed. Consequently, German and French bonds should have similar interest rates. But they don't. Are US bonds a good investment if Europe breaks up? Well, I'm reasonably certain that you'll get your money back, but it might not really be worth much anymore.
Are Japanese bonds a good investment right now even though their debt/gdp ratio is about 200%? If you manage to sell them before they lose their value: yes.
Should you buy French bonds now that they are undervalued? That depends on how much you believe in self-fulfilling prophecies. If the markets stopped giving money to the French right now, France would be broke. But so would any other country on the planet including, of course, the US, if investors stopped giving money.
In the aftermath of the latest global financial crisis many people came to realize that markets are sometimes irrational. Well, they have been wrong. Markets are irrational all the time. In fact, it doesn't even make much sense to call them rational or irrational. Markets simply are. They are a tool to accomplish things within a society. They work predictably unpredictably and can be used for great things.
Markets are not some godly wisdom of the many or a harsh judge or whatever picture some people allowed the press to print into their minds after the fall of the Berlin Wall. Markets simply are. They are often useful and should be used. But they should not be confused with some omniscient or even moral authority.
Now to answer my initial question:
"Why would these investors be opposed to an agreement that said that the debtors do not want to issue much more debt in the future?"
Because investors think that other investors might think that other investors might think that other investors might think ... that countries that spend less will achieve less economic growth in the short term (which is quite probably correct). This will produce negative headlines in the press and these headlines will cause the bonds to drop in value. Why would you buy something today if you expect its value to drop in the future?
In a perfect world this very fact would be 'in the price' already. But Chinese Whispers aren't perfect. And everybody knows that they are not.