One of the interesting things about Twitter is that as much as it has democratised near-instantaneous news distribution (after all, the first recorded report about the Osama Bin Laden raid in Abbottabad was a tweeter complaining about helicopter sounds which disturbed his sleep!); it has also distributed the ability to be pithy, smart and yet deeply insightful. One such tweet yesterday summarised the European sovereign risk crises. It said, "Greece was a zit, Portugal is a boil, Spain is a tumour". It doesn't take much for smartaleck one-liners to spread on trading desks. Particularly, if the origins of the quip are traced back to the biggest bond fund manager Pimco.

In the early stages of the Greek crisis, Pimco decided to abandon all sovereign Greek debt and let it's actions be known to the world. The resultant effect was a spike in yields and the increased fragility in the Greek bond market. This was despite the fact that, in of itself Greece hadn't worsened or improved a week before or after Pimco's actions.

But the buyers and holders of the debt instrument suddenly became unsure if these Greek bonds would pay their coupons or the lump sum notionals at the end. So, following Pimco, others began to dump these Greek bonds. The actions of a major player cascaded throughout the market.

Between the early days of the Greek crisis and today, much water has flown and many a bond trading desks have shut shop, central banks are better prepared and governments more aware of the storm they find themselves in.

So, this week as increased fears about Spain's solvency begin — Pimco is watched keenly. Such pithy quips are read as generally indicative of Pimco's market biases vis-à-vis the direction of the European markets. Given the massive size of Pimco, it is generally considered imprudent to not investigate how they see the market, particularly one as volatile and opaque as Europe.

And nowhere in Europe is more keenly watched than Spain. There over the past month, the borrowing cost of short-term debt has virtually doubled.

Spain's government has promised to put in place more cuts. Presumably, such announcements are to convince the bond traders who lend Spain money that it is serious about putting its house in order. Seeing this course of action, others like the notable columnist Paul Krugman have called this "economic suicide". His argument is that cutting spending during a recession is an invitation to increased dis-utilisation of labour and capital. The IMF estimates around 1.8 per cent of the GDP will shrink this year.

In contrast to what the conservative Spanish government has been advocating, Krugman argues that only two true measures are available: one, either exit the euro (which in effect is a fixed exchange rate system, irrespective of Spain's inflation or productivity, with the rest of the world).

Contractionary policies

Then deflate the new currency and export ones' way back to normalcy. Or the second option is the ECB must accept the prospect of higher inflation, expand money supply, increased spending by Germany (even if it means deficits) in rest of Europe. As if on cue, the Spanish ministers promised to do the exact opposite. They'll increase taxes and reduce spending to generate revenue around €27 billion, which would help bring down the deficit from 8.5 per cent to 5.3 per cent.

Where does this leave us? Krugman's call for expansionary monetary policy assumes that central banks can still get away, and effect the markets, with what Mohammad Al Erian of Pimco calls "unusual central bank policy"? A rising consensus is that the other institutions in the European economy haven't risen to the challenge of addressing the fallout of the economic crises. The central banks have been trying to stem the economic downturn, but any kind of meaningful revival involves the political landscape.

In absence of the other wheels of the economy holding up, the efficacies of the ECB's actions are progressively suspect. And if Pimco's statements are any guides to how the larger bond market thinks, few expect the ECB to help address the Spanish crises. It seems we are destined to hear about Spain for a while. Perhaps, a good excuse to read Don Quixote again.

 

The columnist works for a major European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.