Posting has been slow, because I’ve been preoccupied with an assignment for my International Monetary Theory course. The prompt asks to explain the convergence of Eurozone yields on sovereign bonds,
I didn’t have as much time as I wanted, or should have taken, as the paper is due today. But, here is a skeleton of my rationale,
- Capital market liberalization doesn’t have sufficient explanatory power, because it predicts that interest rates will converge at a point between the lowest and highest rates. Instead, what we see is that all rates fall to around 4 percent;
- One caveat to the above rejection is the possibility of a German balance sheet recession between 2000–05 (Koo ), where debt repayment led to an increase in savings, used to buy foreign assets. I argue that it’s unlikely that an increase in German savings alone accounts for the extent of the Eurozone-wide drop in sovereign bond yields;
- I argue that the spread between the yields reflects differences in risk premiums. I focus mostly on Greece and Spain, noting that both have similar macroeconomic trajectories: economic booms between ~1950–70, and then stagnation, high inflation, and public debt accumulation between ~1975–1990;
- The Maastricht Treaty, in 1992, imposed upon soon-to-be Eurozone members certain fiscal and monetary requirements. These, along with rapidly improving fundamentals in Spain and Greece, may have assuaged investors’ concerns;
- Finally, the European Central Bank (ECB) accommodated German needs during their balance sheet recession, signalling to investors that the ECB is willing to intervene to support struggling markets. Recent experiences provide some evidence for this explanation, knowing that rates on PIIGS’ bonds skyrocketed when it was clear that the ECB would push for internal devaluation and fiscal austerity over monetary devaluation. Yet, when the ECB declares its “limitless” intentions to buy sovereign bonds from struggling markets, some of these countries experienced sudden reductions in borrowing costs.
In short, my explanation is that it’s all about the risk.