A few days ago I wrote about an article in the New York Times, that appeared to say that investors were fleeing the lower interest rates paid by European countries for the higher rates that the U.S. is paying. I was puzzled, as the argument made by the expert in the piece appeared to be somewhat inconsistent with the law of supply and demand. Why, I asked, did a perceived higher quality product cost less than risky Italian bonds? Put another way, if American bonds are so special why aren't we charging more, in the form of lower interest rates, to buy them.
Well, along comes Paul Krugman, to explain the real reason for the disparity.
So, here’s the question I was just asked: How can it be that interest rates on U.S. government bonds are so much higher than on European bonds — not just German bunds, but even Spanish and Italian bonds are now paying less than their U.S. counterparts. My correspondent asks, Is the U.S. government really a riskier bet than that of Spain?
The answer is no, it isn’t. In fact, investors assign virtually no risk premium to holding U.S. government debt, and rightly so. I mean, even if you thought the US might default in the next 10 years, what, exactly, would you propose to hold instead? A world in which America defaults is one in which you might want to invest in guns and survival rations, not German bonds.
In that case, however, what explains our relatively high interest rates?
Well, let’s compare with Germany, also perceived as almost completely safe — but paying much lower interest. Why?
The crucial point here is that German bonds are denominated in euros, while U.S. bonds are denominated in dollars. And what that means in turn is that higher U.S. rates don’t reflect fear of default; they reflect the expectation that the dollar will fall against the euro over the decade ahead.
But why should we expect a falling dollar vis-a-vis the euro? One big reason is that European inflation is very low and falling, while the U.S. seems to be holding near (although below) its 2 percent target. And other things equal, higher inflation should translate into a falling currency, just to keep competitiveness unchanged. If you look at the expected inflation implied by yields on inflation-protected bonds relative to ordinary bonds, they seem to imply roughly 1.8 percent inflation in the US over the next decade versus half that in the euro area, which means that the inflation differential explains about 60 percent of the interest rate differential.
Beyond that, there is good reason to expect the dollar to fall in real terms over the medium term. Why? The relative strength of the US economy has led to a perception that the Fed will raise rates much sooner than the ECB, which makes dollar assets attractive — and as Rudi Dornbusch explained long ago, what that does is cause your currency to rise until people expect it to fall in the future. The dollar is strong right now because the U.S. economy is doing better than the euro area, and this very strength means that investors expect the dollar to fall in the future.
So that’s what the Germany-US differential is about: higher US inflation (which is a good thing) plus the expectation that the dollar-euro rate, adjusted for inflation, will eventually revert to a normal level. Ultimately, it’s all about European weakness and relative US strength.
So, the disparity in interest rates does say something about the relative strengths of the economies involved, but not for the reasons cited in the Times article I discussed in my previous post. In a sense, simply comparing interest rates when different currencies are involved is like comparing apples to oranges. If everything were translated into dollars or Euros for comparison purposes, the effective rate of return, taking into account the anticipated change in the value of the currencies involved, may be higher in Europe (or the same) than that in the U.S. Of course, the investors could turn out to be wrong. The dollar may not fall against other currencies, in which case U.S. investors may do relatively better. (At least I think that would be the result).
This is yet another example of an amazing innumeracy in the press and among some experts. It reminds me of our media's insistence on directly comparing unemployment rates in the U.S. and European countries, without correcting for the various ways in which unemployment rates are measured in the countries involved. See, here, in the Wall Street Journal of all places, on the unemployment issue.
So, that's a question answered.
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