The major world economies are going through a debt crisis, the euro area is struggling to find a sustainable path, and political brinksmanship in the US congress contributed to a downgrade to the US credit rating.
Despite some optimism about recent US economic numbers (I want to do a post on this topic, but I am currently focused on writing a PhD paper) the western economies seem headed for a recession and for some countries this will slip into a
The basic formula for interest rates that we teach to undergraduates is nominal (money) interest rate = the real interest rate +
inflation. This can be rearranged so that real interest rate =nominal (money) interest rate – minus inflation. Real interest rates are often thought of as stable or relatively unchangeable over time, so most of economic analysis is often concerned with inflation
rates. Normally, real interest rates go up if a country experiences deflation. I have, of course, argued on these pages that prolonged deflation is necessary for countries in the euro zone to become competitive.
However, I believe that deflation is not a necessary requirement for real interest rates to go up in this era of sovereign debt crises and unstable political arrangements. It is hard to imagine that the sovereign risk of the world’s largest economies (including Germany) will not rise substantially over the next decade and with it will be a rise in real rates. With many countries defaulting or printing money to escape their real debts it is difficult to see how creditors will not demand a higher risk premium.
Adjustments of real rates are mainly a question of changing perceptions as we are now seeing with Italian bonds. Italian 10 year bonds have averaged 4.46%, since 2001, while inflation has averaged 2.2%, leaving a real interest rate of 2.26%. Last week, global investors woke up and (accurately, but two years late IMO) perceived Italy to be much riskier than before and the 10 year rate rose to 7.48%, forcing the resignation of Berlusconi. Italian inflation is currently around 3.07%. The real rate of interest being charged rose to 4.40% an increase of 95% above the average.
This, of course, creates a severe negative feedback loop which can turn into a viscous cycle as higher rates make it more difficult for a country to regain a sustainable economy path due to rising debt service costs necessitating more cuts and tax increases which in turn are negative for growth.
It is unlikely Monti will be able to deal with Italy’s problems any better than his predecessor. Adjustments for Italy within the Euro area will either come through Germany or deflation. It matters little who is at the helm in Italy. After the resignation, the 10 year rate fell, but it is once again on the rise, up today 37 basis points, to 7.07%. To quote Tuco, from the Italian made (spaghetti) western, ‘The Good, Bad and the Ugly’:
“Who the hell is that? One bastard goes in, another one comes out.”
What is happening in Italy, will eventually happen for all western economies, until systematic and sustainable changes are made to restore internal and external balance to global economies. This will have a significant negative impact on global growth because so many borrowers, consumers and businesses, are on the short end of the yield curve. On the inevitability of such real interest rate increases, I quote Ben Wade, from a more recent western, ‘3:10 to Yuma’:
“Oh, they're coming, Dan. Sure as God's vengeance, they're coming."
Investors better get out of Dodge or grab a gun.