German interest rates: That which is seen and that which is not seen

2012-06-01

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The highest yield on German bonds, is 1.76 for the 20-year bond, which is stunningly low. Image credit: Bloomberg. Data taken on June 1, 2012

Germany is borrowing at record low interest rates. The most common conclusion drawn by observers of this phenomenon is that investors are acting against their own interests, as they are putting their money in investments that will not yield them any substantial returns.

The rationale along these lines is that in times of crisis, the principles of mainstream economics do not hold, since under extreme conditions anything can happen. As such the otherwise rational markets seem to act in an irrational way. Alternatively it is alleged that the fall in Germany’s interest rates is an indication that the eurozone is in an advanced stage of disintegration, with capital flowing to the presumably safest destination, in order to survive the coming economic calamity. A third view comes from those who emphasize that investors prefer to hedge their capital from inflation and the safety of German bonds is seen as ideal for that end. These views often overlap one another, producing a rather persuasive interpretation.

Though there certainly are elements of truth and sound reasoning in all of these hypotheses, I believe they do not strike at the heart of the matter, as they completely neglect several aspects of the broader issue, examining instead the phenomenon in (relative) isolation.

The plain fact is that European banks can use the acquired German bonds as collateral for cheap liquidity from the ECB, or if they are scrupulous enough, they might as well incorporate them as good collateral in structured financial derivatives, in order to enjoy a bonanza of exorbitant short-term profits.

In addition German bonds are considered top quality assets on the banks’ balance sheets, as they are thought to bear zero risk. They therefore have the effect of improving the capital adequacy of the banks that hold them, by diminishing perceived risk. This is of crucial importance to all European banks, since by June 30, 2012 they will have to comply with the capital adequacy criteria (minimum 9%), agreed upon on the October 26, 2011 European Council summit.

Thus the lower yields on German bonds, the natural outcome of excessive demand, are based on the assumption that Germany will retain its triple-A credit rating in the medium-to-longer term (which is directly related to the perceived risk involved). Had it not been for this assumption, German yields would be higher as investors would be willing to invest in other Eurozone bonds or if they were bearish enough they could withdraw their capital from the Eurozone altogether.

The seemingly bizarre phenomena that occur in the eurozone are very expectable and quite reasonable, as they are the end result of a complex, interweaving web of ineffective, ad hoc half-measures that attempted to: (i) protect bankrupt bankers from their deserved failure, at the cost of zombifying the European banking system by propping up unsustainable entities, (ii) divert attention from the desperate need of a thoroughgoing redesign of the eurozone, through policies that obfuscated the systemic aspects of the crisis.

As for the tissues of moralistic pontifications, peddled by some statespeople like Mr Hollande (or the reverse by Mr Weidmann), asking whether it is fair or not for Germany to enjoy near-zero rates while Spain is suffering from usurious ones; I may only say that this discussion is reminiscent of the kind of debates held by medieval monks, who in their ruminations, inquired about the number of angels that can sit on the head of a pin. Markets are amoral and only act on the basis of incentives, with the shrewdest of their actors being adept on exploiting their cozy relationship with the state apparatus and the power elite, so as to abuse with impunity all loopholes in the system.

A closer examination of the subject under discussion, brings us to the conclusion that there is nothing irrational in the way bankers and financiers are behaving. Whether their actions are objectionable or not, is something that should have been thought clearly and carefully before implementing perverse policies. With all of the above in mind I am afraid to point out that the irrationality lies in the policy-makers who insist on remedies that could perhaps cure another crisis, certainly not this one.

“The devil is in the details”, as the saying goes. In this case these “details” are the unseen aspects of a given phenomenon, its numerous causes and its unpredictable ramifications; all of which European leaders have been keen on avoiding, as if the real problem can be forever ignored. Yesterday, after two years of bungling and dithering, European Commissioner of Finance Mr Oli Rehn and Italian Prime Minister Mr Mario Monti, admitted that the Eurozone is fighting for its survival.

Reality strikes back with vengeance…

[Note that the title of this article –“seen, not seen”– is inspired by the well-known parlance of Frederic Bastiat. I am fully aware that he was referring to opportunity costs, but I still think this phraseology is accurate in describing that which I wished to point out.]