Greek Bond Yield Rise May Be a Happy Return to Old European Normal
European bond yields had calmed down as people believed that the worst of the European financial crisis and economic problems were behind them. Yet, in the past month the yield on Greek bonds is up over 300 basis points, with a 100 basis point rise in one day last week. This is restarting fears that interest rates on other European country bonds will rise to unaffordable levels (they have crept up a little already). The problem, however, is not the yields but the level of debt with which the countries are now burdened. After all, the Greek bond yields are just a return to the old normal.
The conventional wisdom today seems to be that government bond yields in the range of 7 to 9 percent are the kiss of death for a developed country government due to their inability to afford to refinance their debt at those levels. Yet, historically such yields are completely normal. This is not ancient history; one only needs to go back to 1996 to find levels of 10 percent for Italy and Spain, 1992 for Ireland, and 1990 for France. In fact, for the last fifty years, Italian bond yields have spent more time in the supposed "danger" range than below it.
In fact, European bond yields are still low by historical standards even after their recent rise. What is different is the level of debt that the countries now need to finance. Italian government debt is 30 percent higher as a percent of GDP than before the financial crisis. The data on Greece's government debt is questionable, but their debt is likely up by 50 percent. Portugal's government debt has actually doubled as a percent of GDP.
What is going unacknowledged by all the Keynesian voices continually pushing for government deficit spending is that their futile attempts to create economic growth by moving money from one pocket to another are causing enormous increases in the risk of government financial collapses at the hands of the bond market.
Deficit spending has failed to produce vibrant recoveries in any of the countries that tried it following the 2008 financial crisis. Germany did the least and has performed at least as well as and generally better than its surrounding neighbors. The failure of such fiscal policy is fairly simple to understand when you realize that the deficit spending is funded with borrowing that would have gone to some other purpose if not used by the government instead.
Keynesians believe government deficit spending will stimulate the economy based on some concept of savings as not participating in the economy. If money came out of a mattress in order to fulfill government demand for borrowing, it would indeed stimulate the economy. If, however, the saver planned to invest the funds in something, then the government borrowing merely replaces other investment spending and creates no actual growth.
What this means is that governments and central banks have burdened their economies with enormous debt without any gain in economic growth to show for it. Now, interest rates that historically were perfectly normal have the power to bring nations to their knees. This has several costs for all the countries now in that boat.
First, the risk of national illiquidity at any moment that bond markets decide to push interest rates to unsustainable levels places constraints on the economic policy of these countries. A country with legitimate reasons to justify borrowing may instead pass up an opportunity to invest in infrastructure or otherwise beneficially use borrowed funds because they are scared about the impact on their total debt and interest burden.
Second, government tax revenue will be diverted to debt payments rather than a more proper use of government funds for the general welfare of a country. In order to provide the same level of service in basic government functions (such as national defense), a government would have to increase tax revenue by an amount equal to the elevated interest payments on their national debt. This increased tax collection adds to the deadweight loss and distortions in the economy from the collection of those taxes. In other words, more taxes are a drag on economic growth.
Third, the government's necessity to keep interest rates low means lower returns to savings in these countries. Lower returns to savings means less saving, leading to lower investment levels and a decline in economic productivity and even labor productivity (since workers have less capital to work with). That means lower economic growth and lower wages in the long run. Countries that save less end up poorer.
There is no such thing as a free lunch; somebody gets the bill. Deficit spending was not free, and now one of the costs is historically normal interest rates on government debt are unaffordable for many countries. The government suppression of interest rates on their ballooning debt, aided by their central banks (quantitative easing, anyone?), hurts savers and points to slower economic growth and lower incomes in these countries' futures.
Policy makers need to ask themselves why historically normal interest rates are no longer affordable. The answer is that the interest rate levels are not the problem, the debt levels are. Seeing the problem clearly is the first step to solving it.
