What Size is the Fire Exit?

BRUSSELS – The eurozone is being thrown into turmoil by a collective rush to the exits by investors. Yields on government debt of peripheral eurozone countries are skyrocketing, because investors do not really know what the risks are.

Officials want to be reassuring. Investors should not worry, they argue, because the current bailout mechanism – the European Financial Stability Facility (EFSF) – has worked so far without any haircut for bondholders, and will continue to be applied until about 2013. Only after that date would any new mechanism open the door for losses for private investors, and only for debt issued after that date.

But markets do not trust this message – and for good reason: it is not credible, because it makes no economic sense. After all, the claim that the risk of loss will arise only for debt issued after the new crisis-resolution mechanism starts in 2014 implies that all debt issued until then is safe, and that insolvency can occur only in some distant future, rather than now, as in Greece and Ireland. In effect, EU officials are saying to investors, “Whom do you believe – us or your own eyes?”

Moreover, for too many investors, Portugal, with its poor growth prospects and insufficient domestic savings to fund the public-sector deficit, looks like Greece. And Spain clearly has to grapple with its own Irish problem, namely a huge housing over-hang – and probably large losses in the banking sector – following the collapse of an outsized real-estate bubble. The problems of Portugal and Spain might be less severe than those of Greece and Ireland, but this apparently is not enough to induce investors to buy their government debt.