EU Rates
Lenders to governments run two types of risks: credit risk (the country won't pay back 100% of the loan), and currency risk (a country borrowing in its own currency can pay back the loan by "printing money").
Developing countries often borrow loans denominated in a currency like the US $, to remove currency-risk. Despite this, they have to pay higher rates of interest because they are not great credit risks.
Countries have defaulted throughout history. Yet, consider the chart on the left. After European countries joined the Euro, interest rates on their borrowing became almost equal. And, notice how that finally ended around 2008, with the "great recession".
Why were rates nearly equal for about 9 years?
The main assumption: Merely agreeing not to default is meaningless. As for the limits, countries were exceeding those deficit limits pretty soon. Essentially, lenders were relying on the idea that Euro countries would hang together when push came to shove. Imagine a lender in 2001 thinking: "if Portugal gets into trouble, the Germans will bail them out". It would be a decent guess, but surely there was also a some chance that Germans would shrug? Surely more probability than shown by the near equality of interest rates paid by the two countries. In retrospect, it seems bizarre that creditors were lending money to Portugal and Germany at the same rate.
The assumption questioned: Starting around 2007, people began to question the idea that Germany would bail out the poorer countries. Increasingly, lenders figured that Greece or one of the others would default. Finally, in 2012, Greece did default. Subsequently, fear has receded as the ECB has said they will supply as much liquidity as is required to hold things together. Rates that had spread far apart came closer, but there are still spreads between different countries, as can be seen in the chart above. (Today, Europe is debating is Cyprus should be allow to default, or if they should be bailed out.)
In the long term: I think the biggest lesson is how long it can take for things like this to play out. Governments like the U.S., Japan, the EU, and even China have a lot of resources. They can bring these resources to bear, to impact market prices. Even if one is right that they cannot keep irrationality at bay forever, they can do so for a long time. Keynes said, "Markets can remain irrational longer than you can remain solvent". Of course, in this case, it is not about markets being irrational. Maybe we should add to that quote: "...and governments can stay irrational far longer than any market can".
Japan and the U.S.: Since the housing bust, a few people have feared that huge amounts of money-creation in the U.S. and the huge deficits will cause huge problems, while others have pooh-poohed the idea. The truth is that if the U.S. continues to pile on debt, it will create a serious crisis some time down the road. The U.S. could well change -- countries do. Still, even if it does not, it can be years before one sees the effects. Consider Japan, that has been in a recession for two decades, and has run up debt that is far greater than the U.S. It appears to be getting closer to show time for Japan, but one could have gone bankrupt the last 20 years thinking it was going to break.
Developing countries often borrow loans denominated in a currency like the US $, to remove currency-risk. Despite this, they have to pay higher rates of interest because they are not great credit risks.
Countries have defaulted throughout history. Yet, consider the chart on the left. After European countries joined the Euro, interest rates on their borrowing became almost equal. And, notice how that finally ended around 2008, with the "great recession".
Why were rates nearly equal for about 9 years?
- Under the Euro, countries agreed not to default (default was not envisaged).
- They also agreed to stick to certain deficit limits
- Finally, there was a good possibility that the EU and the ECB would come to the aid of any country in trouble, bailing out their creditors.
The main assumption: Merely agreeing not to default is meaningless. As for the limits, countries were exceeding those deficit limits pretty soon. Essentially, lenders were relying on the idea that Euro countries would hang together when push came to shove. Imagine a lender in 2001 thinking: "if Portugal gets into trouble, the Germans will bail them out". It would be a decent guess, but surely there was also a some chance that Germans would shrug? Surely more probability than shown by the near equality of interest rates paid by the two countries. In retrospect, it seems bizarre that creditors were lending money to Portugal and Germany at the same rate.
The assumption questioned: Starting around 2007, people began to question the idea that Germany would bail out the poorer countries. Increasingly, lenders figured that Greece or one of the others would default. Finally, in 2012, Greece did default. Subsequently, fear has receded as the ECB has said they will supply as much liquidity as is required to hold things together. Rates that had spread far apart came closer, but there are still spreads between different countries, as can be seen in the chart above. (Today, Europe is debating is Cyprus should be allow to default, or if they should be bailed out.)
In the long term: I think the biggest lesson is how long it can take for things like this to play out. Governments like the U.S., Japan, the EU, and even China have a lot of resources. They can bring these resources to bear, to impact market prices. Even if one is right that they cannot keep irrationality at bay forever, they can do so for a long time. Keynes said, "Markets can remain irrational longer than you can remain solvent". Of course, in this case, it is not about markets being irrational. Maybe we should add to that quote: "...and governments can stay irrational far longer than any market can".
Japan and the U.S.: Since the housing bust, a few people have feared that huge amounts of money-creation in the U.S. and the huge deficits will cause huge problems, while others have pooh-poohed the idea. The truth is that if the U.S. continues to pile on debt, it will create a serious crisis some time down the road. The U.S. could well change -- countries do. Still, even if it does not, it can be years before one sees the effects. Consider Japan, that has been in a recession for two decades, and has run up debt that is far greater than the U.S. It appears to be getting closer to show time for Japan, but one could have gone bankrupt the last 20 years thinking it was going to break.
"A turkey is fed for a thousand days by a butcher;
every day confirms to its staff of analysts
that butchers love turkeys
'with increasing confidence'. " - Nassim Taleb
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