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Friday, November 12, 2010

EU Digs Itself Deeper

I wrote yesterday that markets have a "herd mentality" that reacts to situations with a mixture of fear and greed (depending on the nature of those situations).

Whilst this observation may be "obvious" to many people, it seems that those who claim to lead the EU have not yet understood it.

European finance ministers are now engaged in a massive damage limitation exercise following recent pronouncements from the German Chancellor, Angela Merkel, who sought to to make bondholders contribute to future bailouts. Unsurprisingly the markets have been "royally spooked" by this, and bond yields have been forced up.

Does this matter?

Very much so if you are a heavily indebted nation (such as Ireland), as yields increase so does the the cost of servicing the debt.

Sadly EU minister have only realised, post the EU summit, exactly what damage their agreement on bailouts has done to market confidence. One is tempted to ask why certain people hold the positions that they do, given that it is clear that they do not understand how markets work?

That is a question that needs to be answered at some point.

However, in the meantime, EU ministers have been furiously backpedaling. They have issued a statement from the tense and divided G20 in South Korea saying that the crisis resolution mechanism that they are discussing, that may force bondholders to share the cost of a bailout, won't apply to outstanding debt.

All very well, except for two problems:

1 This clearly shows that the EU is making up economic policy and plans "on the hoof"

2 The application of this "shared responsibility" to future debt will simply increase future yields (as the markets will need to price in the extra risk)

Like it or not, the EU have managed to undermine a future source of revenue and seriously destabilise and unnerve the bond markets. The result being that countries such as Ireland have been pushed closer to the edge of financial meltdown, as the costs of servicing their debt has risen.

It is hardly surprising that the Irish Prime Minister, Brian Cowen, views Merkel's comments as being less than "helpful"!

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