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Europe: Not As Lucky As U.S.
The U.S. may be bankrupt, but the Treasury still enjoys robust bidding at every bond auction.
The United States enjoys funding its ever-increasing debt in its own currency as the dollar, for better or worse, remains the world’s reserve currency. Because the euro and the pound sterling do not enjoy this status, the smaller economies under the European Union's stability pact are having trouble attracting investors for government debt.
This comes as news to nobody in the euro zone, but what surprised many was that a German bond auction failed the first week of the new year. Such a failure is an ominous sign that current government yields won’t secure investor demand to fund the massive European stimulus that is yet to come.
The United States has an integrated (but by no means efficient) monetary and banking authority under the auspices of the Federal Reserve and the Treasury. Europe does not. The European Central Bank does not have the authority to set rates or sell debt on behalf of any sovereign nation. What is good for Germany, say, with its export-based economy, does not necessarily benefit Spain, which depends on foreign investment and suffers a substantially higher debt-to-GDP ratio.
The Federal Reserve appears to be fully committed to expanding its balance sheet at the expense of credit quality. The Treasury seems ready to aggressively fund the borrowing needs of the United States with weekly issuances of T-Bills and T-Notes. With nearly $9 trillion already pledged in stimulus, bailouts and rescues, the U.S. has mortgaged 50% of its annual GDP in an attempt to stabilize the financial markets.
Europe, in turn, looks to its erstwhile economic leaders – France, Germany and the UK – but sees little unity there. Germany is pledging a stimulus of 2% of GDP, but France is balking, and the UK will face difficulty in raising more cash than it already has. They will not be the only ones.
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Fiscal spending has never created lasting wealth. The Keynesian model is a tried-and-true failure. Monetarists like Milton Friedman and Alan Greenspan have tried to employ monetary policy to control short-term interest rates – well, the past two decades have revealed the degree to which the resulting boom-and-bust cycles have been a success. In a fiat-based currency system, easy money engenders irrational risk models and unsustainable asset values.
Given the history of currency devaluation and systemic defaults over the past several hundred years, you might think we would have learned something. But rational thinking is the rarest of commodities when fear is as tangible as it has been.
The United States is bankrupt. The total government liabilities of Medicare and Social Security now total $56.4 trillion. As of January 2009, this amount is now greater than the total net worth of all Americans. The debt equates to more than $480,000 per household. Currently, the average U.S. consumer owes $1.4 dollars for every $1 of income. Nevertheless, the Treasury still enjoys robust bidding at every auction. The Treasury can literally refinance four-week loans at no cost. Institutions worldwide prefer to have their money on deposit with the Fed, or invested in treasuries at a negative real rate of return – just to ensure capital preservation. Fear indeed.
Europe, however, is finding limited demand for euro-based debt. Funding auctions are being postponed or withdrawn due to insufficient bidding. The only answer is to offer higher yields in order to attract investors. Europe will see record debt issuance over the next year, requiring maximum flexibility in the EU stability pact. But, because bond yields are now at historic lows (in both Europe and the U.S.), future interest rates may become onerously high when the time comes to refinance this debt. Certainly bad news for any hopes of a quick euro zone recovery.
Adapted from an essay by EWI's Senior Bonds Analyst Bill Fox that originally appeared in the January 2009 issue of EWI's monthly Global Market Perspective. Bill Fox has been involved in the markets since graduating in 1988 from Vanderbilt University. He joined EWI in 1994; most of his Interest Rates Specialty Service subscribers are professional bond traders spread around the globe.