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The European Central Bank building (JOHN MACDOUGALL)
The European Central Bank building (JOHN MACDOUGALL)

Eric Reguly

Don't blame the bond vultures Add to ...

Talk to some European Commission officials and they will tell you, in hushed tones, about the great dark conspiracy: There must be a master plan to attack the euro zone's sovereign debt. It's as if they envision bloodless, zombie traders huddled in safe boxes in the bowels of Wall Street or the City of London, methodically hitting the "sell" or "short" buttons on their blinking doomsday terminals. How else to explain the debt implosions in Greece and Ireland, and soon, apparently, in Portugal, Spain and even Italy?

To the conspiracy theorists, the attacks are both co-ordinated and irrational. Why did the traders take down Greece first, when Ireland's ample problems were well known more than a year ago? Why was Ireland considered an easy target when it, unlike Greece, came clean on its problem early into the financial crisis and unleashed a heroic (though futile) effort to spare itself from destruction? Why is Spain touted as the next victim when it, on paper, seems in no worse shape than Italy?

The "market," to use an amorphous term for the international cadre of investors and short sellers who are turning euro zone debt into mush, may be guilty of irrational timing. But there is nothing irrational about the identity of the victims. Whoever invented the acronym PIIGS a year or two ago to refer to the countries most vulnerable to debt collapse - Portugal, Ireland, Italy, Greece, Spain - was a canny forecaster.

What the protectors of the euro zone in Brussels, Frankfurt and Berlin realized too late in the game is that however the market acts, it is relentless, powerful and likely to win. The financial firepower brought to bear on the weaklings is the equivalent of deploying a 120-mm cannon to gun down rabbits. This should have come as no surprise to the euro zone's defenders.

Hedge fund king George Soros once attacked the pound, forcing Britain to withdraw from the European exchange rate mechanism (the narrow currency trading band that was the precursor to the euro). His short-selling strategy earned him $1-billion (U.S.) and humiliated the Chancellor of the Exchequer. That milestone in the currency wars happened 18 years ago. Imagine how much more financial firepower the currency and debt speculators have today. Ten times, 20 times?

Greece finally succumbed to the debt marauders in May, when it took a €110-billion ($147-billion) bailout from the EU and the International Monetary Fund. The figure bought relative peace for six months, then Ireland came under fire even though it was slogging through its third austerity program since 2008. At that point, the herd mentality kicked in.

Why then, and not two or three months earlier or later, is a mystery, given that Ireland's financial and economic woes did not appreciably change in the second half of 2010. Irish bond yields soared and Ireland was forced to take the €85-billion bailout it had denied it needed. Having trampled Ireland, the herd did a U-turn and headed south to Portugal and Spain. Portugal could be forced to take a bailout any day.

Euro zone leaders and finance ministers were their own worst enemies. They skillfully used mixed, and sometimes contradictory, messages to bait the bond assassins. Two examples stand out. Early in the year, Germany was hesitant to bail out Greece because Greece had lied about the true extent of its debt and had turned tax evasion into a national sport. With Greece apparently headed toward default, Greek bond yields went on a rocket-propelled ride to the moon. Only then did Germany endorse a bailout.

Germany misjudged the market again in late October, when it casually suggested that private bondholders subsidize future bailout costs by taking "haircuts" on their holdings. Yields of the weakling countries duly rose, pushing Ireland off the cliff. Portugal and Spain may be the next victims; their bond yields were setting record highs almost every day this week. But given the haphazard timing, why not go for the big lasagna - Italy - the euro zone's third-biggest economy?

Italy has at least four "red cards" against it, says BNP Paribas Fortis chief economist Freddy Van de Spiegel. It has the euro zone's ugliest debt load (118 per cent of GDP), and no growth to speak of. It has one of Europe's least-competitive economies, and it has a Prime Minister, Silvio Berlusconi, who seems keener on chasing skirt that solutions (though Finance Minister Giulio Tremonti is well regarded throughout the EU).

Bailing out Greece, Ireland, Portugal and Spain might be affordable - just. Adding Italy, a country that must redeem almost €300-billion in public debt in the next year, would be a bailout too far. If the market effectively shuts Italy out of the debt markets, the euro zone is finished. That scenario is no longer unthinkable.

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Follow on Twitter: @ereguly

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