Photo: Morgan Stanley
In a note on market instability and discipline published today, Morgan Stanley’s Elga Bartsch gives us insight on the elements of a eurozone endgame.In his opinion, the markets have proved unable to accurately assess sovereign risk, but now that a vicious cycle of market cynicism is in the works, the only way to stop it will be direct market intervention.
Here’s more on what’s going on, and how he thinks EU leaders can stop the madness:
– Markets completely undervalued sovereign risk in the eurozone during the first 10 years of the euro. Now it’s overvaluing it.
– Now that government bonds are traded as credit risks, markets can’t find stability. This seriously undermines markets’ role as fiscal disciplinarians. This all happened because governments don’t have a lender of last resort.
– Markets are now pushing towards a ‘sub-optimal equilibrium.’
– A vicious circle is in motion, and the only real answer now is “outright market intervention.” There is no end in sight to ECB bondbuying, and the price of borrowing has made it extremely difficult for governments to stabilise their economies or banking sectors.
– Introducing private sector involvement into eurozone plans is just making markets more volatile by escalating contagion fears. However, it’s not at the root of the problem.
– The Securities Markets Programme (SMP) — in which the ECB buys sovereign bonds — is not a tenable part of any long-term fix.
– The way to make market discipline work and keep some sovereign risk near 0 is by splitting sovereign debt into “senior-sustainable” and “junior-not-so-sustainable” debt, so that the prospect of default does not wipe out stability in the eurozone. This entails two kinds of bonds.
– Excessive lending also contributed to the crisis, and financial regulation by the ECB could be more potent here.