Douglas J Elliott: Eurozone governments and the financial markets - a troubled marriage

12 October 2011

In this Brookings Institution paper, Elliott writes that financial markets and the governments of advanced economies around the world are inextricably tied together in an unbreakable marriage. Right now, the eurozone is a prime example. The financial markets do not seem to understand or trust the governments and those sentiments are returned by many policymakers, including key ones.

Elliott's previous paper* laid out the painful political constraints that explain some of the confusion and apparent irrationality in the government responses to the euro crisis. This paper tries to explain why the markets react as they do to those government decisions and signals. It addresses these key points:

• Eurozone sovereign bonds lie on a spectrum between national bonds and eurobonds, from a financial perspective.
• Changing perceptions of where bonds are on that spectrum can substantially alter their value, which explains why prices of bonds of troubled countries are so closely linked.
• Bond prices are inherently more affected by risk perceptions than by upside potential.
• Eurozone governance is so complicated that it is natural that markets misjudge policies at times.
• Speculation in troubled eurozone bonds plays a significant role, but one which is often exaggerated.

One thing is clear. Normal market functioning, and sustained lower interest rates for the troubled eurozone bond markets, will not be restored until “real money” investors can be comfortable again making long-term commitments to these markets.

Full paper

* “Why can’t Europe get it right the first time… or the second… or the third? View

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