If they continue on their current course, the architects of America’s fiscal and monetary policies might want to consider the above revision to Emma Lazarus’ great exhortation on the pedestal of the Statue of Liberty. For it is in no small measure the flight of capital from investment on other shores that’s has been driving down yields on United States Treasuries, allowing the US to borrow with remarkable abandon despite ratings downgrades and Washington’s ongoing budget follies. As forbidding as the US debt and deficit might be, last year investors continued to bid up America’s debt, lowering the interest cost to finance economic stimulus programs while keeping tax rates unchanged. This injection of capital has almost certainly helped to spur the nascent US recovery, just as some economists argue pre-war European flight capital helped lift America out of the Depression in the later 1930’s.
Washington has had various factors to thank for the easy credit terms the world continues to offer. From Iranian saber-rattling to Japanese earthquakes, many forces served to drive frightened capital into the arms of the US Treasury market. However, at the top of the list is surely the political leadership of the Eurozone. The Obama-Boehner show has nothing on the extravaganza headlined by Merkel and Sarkozy, with a supporting cast of various and changing guest stars governing the solvency-challenged PIIGS (Portugal, Ireland, Italy, Greece and Spain) and of course the folks at the IMF and ECB (every comedy needs a few straight men and women, after all). This noisome cavalcade had provided a continuous flow of confidence-shaking news, keeping sovereign default risk and systemic shock ever present in investors’ minds. Meanwhile, the US has muddled through a budget deal which, while insufficient in the long run, indicated some capacity for concord even in the current poisonous political atmosphere. Similarly, the Fed, aided by TARP financing, seemed to succeed in stabilizing the American financial system. Through late in 2011, the result was an increase in the cost of euro-denominated borrowing for key large Euro sovereigns with the exception of Germany, the yield on whose bunds declined almost in lockstep with a simultaneous drop in US Treasury bond yields.
At the time of this writing, with the “voluntary” Greek debt restructuring talks dragging on, observers may understandably have a difficult time conceiving of an end to “Euro-fear.” Nevertheless, it is precisely the possibility that, with or without Greece in it, the Eurozone will find a way to get its house in some kind of order that threatens America’s ultra-low borrowing costs. We are in fact seeing some tentative signs of, as Churchill put it, not the end or even the beginning of the end, but perhaps the end of the beginning.
New ECB president Mario Draghi’s Long Term Refinancing Operation ostensibly provides a three-year, multi-hundred-billion euro stabilization line of credit to European commercial banks, but as the ECB is “allowing” (read: encouraging) those banks to use this credit to buy better European sovereign bonds (and avoid having to dump weaker Euro nation credits in bulk) what we’re really seeing is a back-door program to lower European states’ borrowing costs. Because the ECB loans represent money created by the central bank, this is a form of bailout that does not require direct taxation of “core” European nations citizens (e.g. Germans), though to be sure, they may end up paying the price through inflation (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility”) and devaluation, though export-driven economies like Germany actually need a weaker currency more than they might like to admit (“It’s Hard To Make That German Export Wiener Without PIIGS – And That Goes For Chinese Dumplings, Too”).
Second, whether or not the Greek debt restructuring talks result in a formal default or an effective one (and the contemplated 70% write-down will surely be a default in fact if not in name) is not so important as whether the process is orderly. So long as any any write-offs and triggered credit default swaps are handled in a way that does not lead to bank runs and frozen markets, such an event could be kept contagion free. There is no guarantee such a systemically benign scenario will play out, but the aforementioned willingness of the ECB to inject liquidity on a massive scale does provide reason for optimism.
And therein lies the rub for US government borrowing costs: as the Eurozone crisis subsides, so may the safe haven “panic bid” on US Treasuries, causing the yields on those bond to rise and further increasing the burden on American taxpayers of financing the deficit. Indeed, the 10 year US Treasury yield has crept up from below 1.87% in late November of last year to over 2.02%, while conversely (and despite it’s own rating downgrade), France’s ten year debt yield declined to below 2.90% since spiking above 3.73% during the same period. Similarly, the Italian 10 year yield dropped from over 7.36% to less than 5.49%.
To be sure, there are significant benefits to the US economy in this “risk-on” shift; the reduction in Eurofear has bolstered equity markets with a knock-on wealth effect boosting consumption and, yes, tax-revenue even in the absence of a rate hike. Even so, higher T-bond rates translate into an increased cost of servicing America’s heavy debt, so even if the core Euro countries seem to be picking up the tab, their Greek holiday may not come without cost for Uncle Sam.
N.B.: One advantage of a weakened euro – cheaper French wines (in dollar terms), and in particularly that said-to-be-excellent 2009 Bordeaux vintage; for insight into this and all things vino, check wine expert (and Duke econ grad) Jessica Bell’s very excellent webcasts at MyWineSchool.com.