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Cleveland Fed's Bizarre Take on US Debt

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

Two economists at the Cleveland Fed have written a research note trying to explain why interest rates on the 10-year bonds issued by Ireland and Spain are so much higher than those issued by the United States.

It's a truly depressing exercise because the Fed economists manage to reveal that they are completely ignorant about what's really going on.

They dismiss a bunch of things that deserve to be dismissed. The interest rate differential isn't caused by different debt-to-GDP ratios. It isn't explained by differences on growth potential.

So what do the Fed economists think explains the very significant interest rate gap?

First, as the Irish know all too well, banking balance sheet problems can quickly turn into sovereign problems. In the fall of 2010, the Irish government had to intervene to recapitalize the banks, which increased the country’s sovereign debt . In the United States, links between the banking sector and government debt seem to be weaker than in Europe. For example, the claims of domestic banks on their respective governments exceed 20 percent of GDP for all the countries in the EZP [euro zone periphery], while such claims amount to only 8 percent in the United States. The same pattern is true if one looks at overall sovereign debt exposure; less foreign debt is held by U.S. banks compared to their European counterparts. Should the government need to step in and recapitalize banks, as in the case of Ireland, less exposure to banks means that the government’s liabilities are likely to be smaller in the U.S. than in the EZP.

A second factor explaining the difference in interest rates has to do with the demographics of sovereign debt holders. Compared to the EZP, the U.S. has a larger share of domestic holders and foreign official holders such as other central banks. This gives the U.S. the advantage of a very stable investment base. Private domestic holders tend to exhibit some home bias. If they want to hold an asset with the risk-return characteristics of a government bond, they are, everything else being the same, much more likely to hold a government bond of their home country. In turn, these investors are also less likely to shift away from these bonds as prices fluctuate. Furthermore, given the importance of the U.S. economy, foreign central banks may want to hold U.S. treasuries for strategic reasons that do not necessarily reflect market concerns.

Another reason for the interest rate spread is the safe haven factor.

Money managers need to park their funds somewhere, and with a large fraction of European sovereign bonds in trouble, U.S. debt has benefited from an increase in demand. This mechanism has been exacerbated by the recent increase in volatility in capital markets.

Finally, we will finish with a word on credibility. A security does not bear the “safe haven” moniker by chance. The reason U.S. Treasury securities command lower interest rates than say Zimbabwean government securities is partly because both the U.S. government and the Federal Reserve have each made credible commitments; the government pledges to keep the debt at a sustainable level and the Federal Reserve assures that it will not monetize away the debt. These commitments are more credible in the eyes of the public than those made by the Zimbabwean government and central bank.

Notice a couple of things about those four paragraphs. First, each of the "reasons" is just an assertion completely unsupported by evidence.

Second, and more important, there's not a word about the U.S. not ever being at risk of an involuntary default. It's almost as if the economists don't understand the significance of the fact that we issue debt in a currency we control. We can never run out of dollars to repay our debts, unlike the nations of Europe, which can run out of euros.

(Hat Tip: Joe Weisenthal.)

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