By John Bruton
Bond markets are notoriously fickle, often driven by sentiment rather than rigorous macroeconomic analysis, and, as the 2008 global financial crisis demonstrated, they are far from infallible. They can also be particularly unreliable when assessing an economy's long-term prospects.
Though interest rates across the European Union are at historic lows, government debt in the eurozone could come under severe pressure should bond markets re-evaluate the riskiness of sovereign borrowers. That is a consideration that should weigh heavily on indebted governments as they submit their budgets for scrutiny to the European Commission.
It is not just bond traders who can be swayed by irrational exuberance (or its opposite). The verdicts of rating agencies on asset quality can also be flawed. Too often, the raters seem content to follow rather than lead sentiment. Like the proverbial bus driver fixated on what is happening in his rear view mirror rather than watching what is in front of him, too many bond analysts focus on historical economic data as the key determinant of future performance.
It is against this background that the budget plans submitted by eurozone governments on October 15 will have to be assessed. This requirement of the eurozone's Stability and Growth Pact, specified by Article 126 of the Treaty on the Functioning of the European Union, applies to member states that fail to meet their commitments to bring their budget deficits below 3% of GDP.
The main source of concern is that the low interest rates at which most European governments can currently borrow are not likely to last. There are two reasons for this.
First, sovereign bonds held by banks are treated as risk-free assets under EU rules for calculating banks' solvency and capital-adequacy levels. This is a risky assumption, because it implies that no European government will ever fail to repay the bond in full, with all interest due, and on time. But the debt levels of some European countries relative to their income raise serious questions about whether their bonds really are risk-free. And, assuming that there is no surge in inflation or economic growth, the danger of default cannot be so easily dismissed.
Second, with low interest rates causing vast sums of money to chase so few opportunities for decent yields, it is understandable that investors have turned to government bonds, thereby driving down yields still further. But this situation cannot last forever; if the flow of funds slows, or alternative, higher-yielding assets become available, demand for government bonds could drop markedly. At that point, interest rates on sovereign debt would have to rise to sustain governments' borrowing levels.
This is not a far-fetched scenario, and its realization would play havoc with the budgets of many indebted eurozone member states. Therefore, in assessing member states' draft budgets, governments and the Commission would be foolish to assume that low interest rates on government bonds will be around for the foreseeable future.
If investors do decide that government bond yields are no longer worth the investment, sovereign borrowers' options may be limited. They might be able to defy the European Commission, but they would be hard-pressed to resist the views of the bond markets. After all, the world's financial centers are not only susceptible to bouts of irrationality; they are also less likely to be swayed by the sort of political rhetoric that might find some sympathy within the Commission or among ministerial colleagues in the EU Council. Moreover, the market's change of heart can occur very quickly and without warning, giving governments little if any time to make the necessary fiscal adjustments.
But that is less likely to happen if the EU system for coordinating the 18 eurozone members' budget policies (the so-called Two Pack and Six Pack) is seen to be respected - especially by the larger countries, such as France and Italy.
On the other hand, if the system is defied, or reinterpreted in a way that alters its intended meaning, bond markets could once again become nervous. Ireland knows better than most countries the difficulties that can arise from having to borrow to fund services or repay maturing debts.
