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The Year Governments Lost Their Credibility

Floyd Norris. 

The New York Times, December 30, 2011

For most of 2011, it appeared that the year would be decent, if not particularly interesting, for investors.

Then Europe announced its second plan to rescue Greece, the first one, reached more than a year earlier, having turned out to be completely inadequate. That’s when 2011 became exciting and the losses began to pile up.

The summit meeting of European leaders on July 21 in Brussels called for private investors to take losses of 21 percent on some Greek bonds, but for a rescue package to keep losses from being worse. At first markets reacted with enthusiasm, but that deal did not last long enough to even write out the details.

The European leaders had drastically underestimated the problem and misunderstood the risk that fears of default would spread to other countries.

Within weeks, it became clear that 2011 would be remembered as the year that governments lost their credibility. Markets, which had always assumed that major Western governments would honor their obligations, struggled to learn to adjust to a new world where that was not so certain.

At the same time Europe was failing to come to grips with its problems, President Obama was in negotiations with Congressional Republicans over a possible deal to raise the debt ceiling and avoid an American default. In the end, there was no default, but the fact that some politicians seemed to think one was a good idea was unsettling to investors. In August, Standard & Poor’s cut the country’s credit rating from AAA to AA-plus.

Oddly, the downgrade of the United States seemed to help its financial markets. Whatever a rating agency might think, the United States seemed to be a bastion of safety and relative certainty. Treasury bond prices rose and yields fell. And the American stock market, while it became extremely volatile, more than held its own. Depending on what index is used, American stocks rose a little or fell a little during the year, although they ended lower than they had been when the European leaders announced their Brussels agreement. The MSCI index for the United States ended with a 2 percent rise.

Late in the year, Europe tried again to find a way out of its financial morass, and may have done a better job. The European Central Bank offered unlimited three-year loans to European banks, which seemed to be willing to take the money — at a 1 percent interest rate — and buy government securities that will mature before the central bank’s loan must be repaid. In the final week of the year, Italian debt auctions produced rates of 3.2 percent on six-month bills, but more than double that for 10-year-bonds. European share prices seemed to stabilize.

The accompanying charts document the trend in share prices for the world and for 12 stock markets, using MSCI indexes to assure comparability, and document how the investment world changed as it became clear that the July 21 Brussels accord had accomplished little. The indexes include reinvested dividends, and are all calculated in dollars. The countries shown are six nations in the euro zone, the area most directly affected by the European deliberations, and six other major markets around the world.

A Rescue That Soured

The year was well on its way to being a decent one for stocks in most countries until July 21 — when European leaders reached agreement on a Greek rescue package that included “voluntary” haircuts for private investors in Greek government bonds. At first, the agreement was well received by markets, but as it became clear that the deal would not hold, stock markets became weaker and much more volatile. Related Article »

On July 22, the day after the Brussels accord, the MSCI world index — which includes markets in all developed economies but not in emerging markets like China — was up 7.1 percent since the end of 2010. Even poor Greece had a stock market that was almost even for the year, thanks to a 7.5 percent rise on that day.

As the year neared an end, the Greek market was down more than 60 percent. From its 2007 high, the market has lost 92 percent of its value. From top to bottom during the Great Depression, the Dow Jones industrial average fell just 89 percent.

The pain was also intense in other European countries. In all of the other five euro zone countries shown — Germany, France, Italy, Spain and Portugal — prices declined significantly after that July meeting. Germany, the dominant economy in Europe, and the one that did the most to keep the bailout packages from growing too large, suffered the most. Italy, down 19.5 percent after the meeting, did the best.

Outside the euro zone, the loss of confidence also echoed. India’s stock market lost nearly a third of its value after the summit meeting, and China’s fell by nearly 20 percent. The losses in the United States, Britain and Japan were smaller.

The rise in volatility was even more impressive. The charts show the proportion of trading days in each market in which prices either rose or fell at least 2 percent during the day. For the world as a whole, the proportion went from 1 percent in the months before the summit meeting to more than a quarter of the days after that. In Germany, about one day in two exceeded that threshold after the meeting.

When the euro was created in 1999, Europeans voiced hope that a common currency would help the Continent reassert its economic influence in the world. In 2011 that happened, although not in the way the creators of the euro had envisioned.

Floyd Norris comments on finance and the economy at nytimes.com/economix.