This begs the question: what is a risk-free asset? While there is no simple answer, financial economics has held that since government debt is generally free of the risk of default, it is a reasonable proxy for a risk-free asset – so long as the investor eliminates the risk of interest rate movements by matching the duration of the government bond with the time horizon of his or her investment.
In the modern era, in most developed economies and in many emerging economies, the default-free ideal was realised by the emergence of pure fiat national currencies. This system gives each national government virtually unlimited power to issue debt which the bond markets regard as virtually free of default risk. This is because each national government has the power to persuade its central bank to increase the money supply and thereby devalue the worth of its debt relative to the prices of goods and services.
Even the supposedly independent US Federal Reserve acquiesced to US fiscal policy in the 1960s and 1970s, leading to the highest rate of US inflation in the 20th century and a prolonged decline in the values of US government bonds.
Until the introduction of the euro, each European country had both its own monetary and fiscal policy, resulting in a wide variety of inflation rates and government bond yields across the continent. The promise of the euro was to bring uniformity to inflation and interest rates across the eurozone, without a corresponding convergence of fiscal policy. Criticisms of the scheme were dismissed in a drive to bring about monetary union at what was considered a unique historical opportunity to do so.
The plan for the single currency was agreed with the signing of the Maastricht Treaty on February 7 1992, resulting in the launch of the common currency and the new monetary authority, the European Central Bank (ECB), on January 1 1999.
Until 2009, the euro seemed to deliver its promise. From early 1992, when the treaty was signed, until the end of 1998, government bond yields converged as predicted. Then until 2009, they remained virtually the same.
However, it was within the apparent success of the single currency that lay the cause of its own demise. Specifically, since the governments of the poorer countries were able to borrow at the same rate as the richer countries, in effect the governments of the poorer countries came to be subsidised by the richer countries.
A basic law of economics is that if you subsidise an activity you get more of it, and since the poorer countries were able to borrow and spend at subsidised interest rates, they did just that. This became an issue most particularly for the Greek government, which has always had difficulty collecting taxes from its own citizens.
The late economist Herbert Stein famously stated that “if something cannot go on forever, it will stop”. The unity of eurozone government bond yields was certainly subject to this law and did indeed stop in 2009. Eventually reality emerged in the bond markets that countries with conflicting fiscal polices cannot have the same government bond yields.
However, there is an important difference between the diversity of yields before the euro era and those of today. In the past, differences of yields were largely due to differences in the rates of inflation across countries, which were rooted in differences in monetary policy.
Since today the poorer eurozone governments cannot set their own monetary policies, the only option that they have is to default – which the Greek government has already effectively done, albeit not yet in name. Hence the differences in yield are now due to differences in the probabilities that such defaults will occur.
What this means for investors is that they cannot lump all eurozone government debt into a single asset class. It is now more important than ever to look at each government’s creditworthiness on its own merit. Fortunately, the bond markets are already doing this, so that investors can use differences between yields as guides as to which country’s debt they can regard as risk-free and which ones are risky. And they can do this without the aid of the sovereign credit ratings that have proven to be irrelevant.
There is much debate about the future of the euro. At the 2012 Morningstar Investment Conference in Vienna, two leading experts took opposite points of view. Peter Bofinger, professor at the University of Würzburg argued that the euro would survive, while Andrew Clare, professor at Cass Business School in London, argued that it must ultimately at least partially unravel.
What was interesting was that these two economists agreed on the economics of the eurozone. Namely, they agreed that without some sort of fiscal union, the euro cannot continue in its current form. The source of their differences lie in their political outlook. Professor Bofinger predicted eurozone politicians would agree to a fiscal union, while Professor Clare argued that voters of the various European countries would never accept such a loss of national sovereignty.
We can understand the underlying economic problem of the eurozone by referring to the theory of “optimal currency zones”, as articulated by Nobel-prize winning economist Robert Mundell. According to Mr Mundell, in order for it to be optimal for a group of countries to have a single currency, the following conditions must hold:
- There must be labour mobility, so that people are willing and able to relocate throughout the zone to access jobs;
- There must be capital mobility across the zone;
- The countries within the zone must have similar business cycles;
- There must be a risk sharing system in place across the zone so that money can be redistributed geographically when needed.
What is striking about the eurozone is the absence of these conditions, thus making it clear that the creation of the euro was motivated by politics rather than economics.
Whatever the politicians may or may not do to save the euro, what is most important to investors are the choices that they now face across the investment landscape. What is apparent from the sovereign bond yield curves is that while the euro might still exist as the common medium of exchange across the zone, it has ceased to exist as the basis for a pan-European risk-free asset. As far as asset allocation is concerned, the euro is already dead.
Paul Kaplan is quantitative research director at Morningstar Europe