Low Bond Yields in Europe Could Signal Deflation

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By Peter Coy,

from Bloomberg Businesweek,

News flash: Spain is now able to borrow almost as cheaply as the U.S. Yes, Spain, a nation with 26 percent unemployment, red ink in the national budget, and an economy that has shrunk in 17 of the last 23 quarters, has five-year government bond yields of just over 1.7 percent. Italy’s borrowing cost is only un po’ più elevato. Even Portugal has a government bond yield merely a percentage point higher than that of the U.S.

Now for the asterisk, because things are never simple in Europe. It’s unquestionably good that the peripheral nations of Europe have stepped back from the brink of default, emboldening investors to accept lower yields on their government bonds. The problem is that the very austerity measures that lessened the risk of default may have contributed to a new danger in Europe: deflation. To use a metaphor from Greece, whose government borrowing costs have also plunged, Europe managed to steer clear of the rocks of Scylla only to head for the whirlpool of Charybdis.

Past a certain point, falling interest rates go from being helpful to a little scary. An extremely low interest rate can signal that investors have no faith in a country’s ability to grow on its own and that they expect central banks to keep official rates superlow for a long time to gin up economic activity. One thing that continues to depress European economies is fiscal policy: the combination of spending cuts and tax increases that helped governments prove they were serious about balancing budgets and winning back investors’ confidence.

In France, five-year government borrowing costs are 0.9 percent, which is well into dangerous territory. French President François Hollande is trying to get permission from the European Union to slow the country’s deficit-reduction effort, which he believes is partly responsible for France’s economic weakness. The country hasn’t had growth of 1 percent or better since 2011. He dispatched two ministers to seek the support of their German counterparts on April 7.

Interest rates fall when the demand for funding is weak because of a big “output gap,” the slack between what the economy is capable of producing and what it’s actually putting out.

But quantitative easing wouldn’t be as easy for Draghi to carry out as it has been for the Fed. The ECB’s founding treaty prohibits it from financing governments, which is essentially what a central bank does when it buys government bonds. Even if it got around that rule, the ECB would have to make politically fraught decisions about which countries’ bonds to buy.

If the ECB succeeded in its mission to stimulate the European economy, interest rates would go up, not down. Stronger growth would increase the demand for loans, and inflation would pick up, both of which would raise the rates lenders and bond buyers demand to let go of their money. So when interest rates fall, it’s a sign that investors expect the ECB to do a lot more to get growth going—and, at least initially, to fail. That, in a nutshell, is why the news flash out of Madrid is not entirely good news.

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