Why bond market yields imply a gloomy future for Europe’s economies

Paul Ormerod
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Angela Merkel: Fiscally prudent, or trending to lower growth?

VERY strange things have been happening in government bond markets. The yield on 10-year US government bonds is currently around 2.25 per cent. It makes intuitive sense that the Germans, with their longstanding reputation for fiscal prudence, are enjoying a much lower rate, of some 0.7 per cent.

Similar levels obtain in most of the countries we might now reasonably think of as Greater Germany, those with close ties to the Federal Republic. So rates are at or below 1 per cent in countries such as Austria, the Netherlands, Finland and the Czech Republic.

Yet it seems to defy reason that rates in other EU countries are below those of the US, sometimes considerably so. Ten-year French government bond yields are below 1 per cent. Almost incredibly, in Spain they are under 2 per cent, lower not just than those in the US but fractionally lower than those in the UK.

The massive falls in bond yields during 2014 are, of course, good news for indebted countries. And the implication that the markets consider the risk of default to have virtually disappeared seems to be to the benefit of all.

But the worldwide trend to lower yields on long-dated government bonds carries some gloomy implications. In the weird and wonderful world of economic theory, there is a marvellous concept that capital is “putty-clay”. An institution sits on a pile of cash, which as it stands can be made into almost anything. But once it is invested in, say, a research and development project, a new Big Data base or in building a new office, it becomes much more difficult to change. The putty has become clay.

At least, that is, for the time being. Given sufficient time, the clay can be transformed back into a much more flexible form. If we pull an even more fundamental tool out of the box of economic theory, that of long-run equilibrium, this tells us that the rate of return on all types of assets should tend to be the same. For the economy as a whole, when investments are made in machines and buildings, the rate of return is simply the rate of inflation plus the real rate of growth. And the same formula applies, in the long run, to government bonds. In the long run, both bonds and fixed investments are putty, not clay.

No one ever made money using this simple algorithm, but in a mad sort of way it makes sense. Bond yields of 1 per cent or less do not just tell us that inflation is expected to be very low. So too is economic growth. Intriguingly, the yield on 10-year bonds in Poland, which is just as closely tied to Germany as the countries mentioned above, is some 2.6 per cent. And Poland has been the most successful EU economy in terms of growth over the long run of the past 20 years. But for the rest of the EU, the message from the bond markets is gloomy.