Some thoughts on European and German interest rates
Last week I had the honor of giving a lecture during the Economists’ Career Day at my alma mater, the University of St. Gallen, to students, faculty members and alumni. My talk centered on the views that we at the CIO team have developed over the last five years regarding the euro crisis. We have written extensively about it in numerous publications, so I will not repeat everything here. However, there is one point I’d like to expand on since someone challenged me on it after my speech.
When I lecture on the euro crisis I usually start by debunking a couple of myths. One is that the financial crisis caused the euro crisis and that, without the disruptions of 2007-08 and the Great Recession that followed them, the euro crisis would never have occurred. Imbalances, especially on current accounts and unit labor costs, were so large among Eurozone member countries in 2007 that, at some stage, they would have had to correct regardless, in my view. Such corrections are usually abrupt and painful. Hence, I believe the financial crisis just accelerated the crisis, which was poised to unfold, likely only a little while later. Nonetheless, during the cocktail reception after the speech, one of my well-esteemed former professors of macroeconomics challenged me on this point.
“By stating that the euro crisis would have taken place even without the financial crisis, you are implicitly exonerating the financial intermediaries from any wrongdoing,” he said. “In my view, they bear an important responsibility for causing the crisis. Allowing the interest rates of the Eurozone periphery to converge to the levels of Germany after the introduction of the euro created the conditions in the periphery for excessive government spending and surging household credit activity. Financial intermediaries should have known that there was no German bailout clause for other Eurozone countries. They should have priced the sovereign bonds of the periphery accordingly. If the banks had done their job by assessing the sovereign risk of these countries correctly, the imbalances wouldn’t have deepened and the euro crisis would never have occurred.”
I countered: “It might be true that the financial intermediaries mispriced the sovereign credit risk of the European periphery, which led to the convergence of Eurozone interest rates before the euro crisis. However, prior to 2009, did you ever hear one Eurozone politician or representative of the European Central Bank express any concerns about this? Or hint about mispricing and warn the financial intermediaries, or any other investor, about the danger lurking before the euro crisis began?”
“Well,” he chuckled, “no official ever complains when interest rates are too low.”
The debate ended there because we were joined by other well-wishers. However, the discussion led me to think: What if the mispricing of Eurozone sovereign bonds has continued? Are we sure that the interest rates governments are paying now in fact reflect sovereign risk? Of course, the euro crisis has left its mark on the European periphery sovereign bond market. Spreads to German interest rates on 10-year government bonds vary from 120 basis points (bps) in the case of Spain to 690bps for Greece. However, one remark you hear quite often is that French interest rates are particularly low.
Given France’s current deficit prospects, debt dynamics and lack of reform, is a spread of only 30bps between it and Germany justified? The usual response is that France still benefits from being “second best” in the Eurozone. Germany alone does not provide enough depth to the sovereign bond market in euros to absorb all the demand for these safe investments. This might be true. But one could equally argue that German interest rates remain too low compared with where they would be in the hypothetical case that Germany still had its own currency. Why? Because without the euro, investors, in my opinion, would have diversified their holdings of European sovereign debt among the different currencies and there would be less demand for German sovereign debt.
It is often said that Germany has been the chief beneficiary of the euro. The common currency has prevented many of its former international competitors from devaluing. Having interest rates much lower than they would otherwise be might be another - substantial - benefit that Germany enjoys. It’s something to bear in mind when assessing how much a hypothetical exit from the euro would cost Germany.