Graph Jokes

Let’s start here:

In case it’s not immediately obvious — I know, it’s not; I can’t figure out how to trick FRED into letting me name the entries in the key whatever I want — blue is Spain, red is Italy, purple is the UK, orange is France, and green is Germany.

There are a lot of stupid things that could be said about this graph, but I’ll try not to say them. A retrospective on the last twenty years would lead you to expect a graph that looks about like this one. The long-term interest rate of government bonds and securities reflects expectations about short-term interest rates and a risk premium, so the Maastrich Treaty (Feb 1992), which required countries to maintain exchange rates within a certain window relative to the Deutschmark and control inflation, should have had the effect of decreasing long-term rates. It would be stupid, of course, to require countries to meet low inflation targets and a narrow exchange rate window if you didn’t think they could do it, so Maastricht signers must have had those tools up their sleeves somewhere. Fine, so investors demanded less of a risk premium.

Then the mid-90s crisis of confidence in the Euro happened, the UK opted out/elected to stick with the pound, Germany and Italy missed some inflation targets, and investors responded by demanding higher interest rates to hold government debt from any of the countries listed on this chart. Because all of them except the UK were anticipating being under the same monetary authority, it makes sense (for now) that their expectations about short-term rates plus risk premiums would stay convergent. Of course, signatories to the Maastricht Treaty survived this crisis of confidence by changing the rules and telling everyone that things would be fine, so long-term interest rates stayed close and the interest rate didn’t jump that much.

That convergence lasted through the early 2000s (except for the UK again, more on this soon) with downward trending long-term rates because, you know, interest rates would stay low and everything was going to keep getting better forever. Those two beliefs together anchored expectations about short-term rates and risk premiums at extremely low levels — compare to the beginning of the series — until the 2008 recession hit, which is where things finally get interesting.

The divergence at the end of the series is also exactly what you’d expect if you knew from the outset that bailouts or any kind of economic support from the EU would require fiscal cooperation that was never part of the original deal. Germany and France are in relative terms doing fine, while Spain and Italy both have huge unemployment — 24.3% for Spain and 10.2% for Italy as of April — that’s trending upward, and a single monetary and fiscal policy has to serve all of them. France’s unemployment is also hanging out at about ten percent, but the key differences between France and Spain are that no one has arbitrarily decided¹ that France has been spending irresponsibly and that France’s unemployment hasn’t destabilized its banking sector, so France doesn’t yet need help.

1 – (from a class lecture, Dr. Arslan Razmi, April 2012)

The divergence at the end of the first chart reflects the inability of Spain and Italy to design policies to fix their own economies and uncertainty over whether Germany — the last Eurozone core to hold the line on austerity — will step in with needed funds. I chose Italy and Spain in the first charts because those economies have been widely described as “too big to bail,” so perceptions of their riskiness matter more than perceptions about Greece or Portugal.

What’s interesting, though, is that the UK, which had either higher interest rate expectations or a higher risk premium for the entire period leading up to the recession, suddenly has rates closer to Germany’s than even France’s rates. What explains this is not only that the UK has its own currency; it also bailed on the Exchange Rate Mechanism, which gives it absolute control over what it wants to do with the pound sterling. In that sense, the UK’s arsenal isn’t yet empty, while Spain and Italy find themselves without any more guns or ammo to throw at their economies. The UK can devalue to stimulate exports and decrease imports; Spain and Italy can’t. The UK can print as many pounds as it wants; Spain and Italy are stuck with the European Central Bank’s money supply decisions.

But Spain’s and Italy’s inability to design their own economic policies aren’t new. They’ve been present for the entire lifetime of the Euro, and the risk that a recession would hit and different Eurozone countries would require different policies has also been present for the entire period. Whence the convergence in the 2000s now? It’s likely that investors just did a bad job estimating risk. We systematically underprice risk on new assets, and the Euro was born in 1999. Now investors seem to be doing a better job — over 20% unemployment is a pretty easy signal to read — but this is something to keep in mind for the next time we’re not in a global recession, long-term interest rates are converging around a low value, and we start to talk about how we’ve “made it” and the market will take us all away in a unicorn-drawn chariot into the moderated business cycles future.

EDIT: The convergence in the mid-2000s is what you’d expect to see if you believed in economic integration and cooperation in the Eurozone, which is something we kind of decided as a group was true. Brad Plumer notes that this was ridiculous though, with a comparison of the Eurozone to some arbitrary hypothetical currency unions including every country in the world beginning with the letter “M.”