Canada, the Eurozone, and interest rates

This is something I know I don't understand. Compare the following two statements:

A: "Some Eurozone countries have higher interest rates on their government bonds, reflecting higher perceived risk of default. This raises all interest rates in those countries, and so reduces aggregate demand in those countries."

B: "Some Canadian provinces have higher interest rates on their government bonds, reflecting higher perceived risk of default. This raises all interest rates in those provinces, and so reduces aggregate demand in those provinces."

I believe that B is false. I see no reason why the risk of default of a provincial government should cause higher interest rates for private borrowers in that province. Replace "province" with "municipality", if you like, and it's even more implausible. If my municipality has too high a debt, why should that affect the rate I pay on my credit card? Just because the province or municipality in which I live defaults on its debt, doesn't mean that I will default on my debt. (Or does it? Are those default risks correlated? Bad times in a particular province or municipality may damage both government and private borrowers' ability to pay their debts. But some private borrowers should still be safer than the government, and will pay lower interest rates.)

But if B is false, why should A be true? Is A true?

I can think of one reason why A might be true but B false. If a Eurozone country defaults on its debt, it may also leave the Euro, issue a new national currency, and pay its debts in that new national currency . And if it does leave the Euro, and pay government debts in the new national currency, it will also declare that all private debts can be paid in the new national currency. And since the new national currency would immediately depreciate against the Euro, that would amount to a partial default. And, most importantly, that partial default would be perfectly correlated between government and private debt. So private interest rates would follow government interest rates higher one-for-one when that default risk rises. And since government default would imply private default, interest rates on private loans should never be lower than on government loans.

I don't see Canadian provinces issuing a new currency if they default (with the possible exception of Quebec?). Same with US states.

So, if we want to estimate the bond market's perceptions of the risk of a break-up of the Eurozone, don't just look at government bond yields; look at private bond yields too. If interest rates on private loans always rise one-for-one when government bond yields rise (relative to Germany), and if private loans always yield higher than government bonds, then that risk premium reflects the risk of leaving the Euro, rather than a simple default while maintaining the Euro.

Does that sound right?

(I haven't looked at interest rates on private loans across Eurozone countries, nor across Canadian provinces. Partly because I'm lazy, and incompetent at getting data; and partly because I want to state the theory first before peeking at the data, to avoid bias. Data nearly always give a fuzzy picture, and it's best if the person looking at the data isn't wedded to a particular theoretical interpretation.)

 

Comments

[Robert McClelland]

If my municipality has too high a debt, why should that affect the rate I pay on my credit card?

It shouldn't, but it's a convenient excuse for your credit card company to gouge you.

[Nick Rowe]

Robert: sellers or lenders don't need an excuse to raise prices. Or, if they do need one, excuses are plentiful. If they can increase profits by raising prices, they will. So why aren't prices infinite already? Because demand curves slope down.

[Kosta]

Isn't the degree to which Statements A & B are true related to the degree which the private markets in each Eurozone country or Canadian province are dependent upon the gov't for funding? The reason why Statement B does not appear to be true is because individual entities in each Canadian province are not beholden to funding from within that province, but instead can tap exterior sources (transprovincial or international).

In the Eurozone, citizens and companies of each country can also access exterior funding -- indeed, before the crash, Eastern European countries were flooded with cheap Euro-denominated credit from the Eurozone (and Switzerland and Sweden). But with the banking crisis, a lot of these trans-border sources of credit have dried up, forcing utilization of domestic sources of credit.

For the Eurozone, the drop in trans-border credit could force up borrowing costs for domestic consumers and companies as they are forced to rely on domestic sources. Because of this, Statement A should be true to some degree. However, the ECB has tried to ameliorate this problem by allowing domestic banks to fund themselves directly from the ECB at 1% rather than their national central bank at national rates. This represents an infusion of liquidity of an unprecedented scale. For example, the banking systems of Greece and Ireland have now received funding worth about 40% and 50% of GDP respectively ... the lending of the ECB to the Greek banking system amounts to an implicit subsidy worth around 2.8 to 3.2% of GDP. Liquidate or Liquefy (21.20.2010) This implicit ECB subsidy keeps Greek private rates lower and supports aggregate demand (that is, Statement A doesn't hold as strongly).

I think Nick's idea about asking whether borrowing costs rise one-to-one with gov't yields can provide insight about the degree to which each country's debt market is isolated from the entire Eurozone market.

[Nick Rowe]

Kosta: I don't *think* that's right. Suppose there were barriers to interprovincial lending/borrowing in Canada. Then we would expect to see different provinces having different interest rates, even on perfectly safe loans, to reflect differences in provincial desired savings and investment. But if the government in one province suddenly had a (perceived) higher risk of default, the interest rate on that government's bonds would rise to reflect that default risk, but interest rates on private loans should stay the same, at a first approximation, if the private default risk stayed the same.

Hang on, maybe you do have a point, on re-thinking this. If the ECB ignores risk when it lends to banks, and lends at the same rate to banks in all Eurozone countries, and lends a big enough amount, then the overall level of private interest rates won't reflect risk differentials properly.

[Patrick]

Nick, Robert: Sorry for the OT ... prices can rise without the consumer being fully aware of how much they really rose, so the demand curve is less steep than it otherwise would be - tricks and traps as Elizabeth Warren puts it. In general, it seems that many businesses think it's a good business strategy to setup their pricing so that it isn't directly comparable to the competition. Just look at how big tech companies sell their enterprise software if you want a really egregious example. Good luck comparing prices. I they do it to because it makes marketing easier to get price out of the way.

[asp]

As far a I understand the logic(sic) of investors, private debt is considered riskier than government debt.

Private companies then land up paying more than provincial governments, and private individuals pay more than companies. I don't think credit cards really are affected by these rates, everyone generally defaults to 19.5% no matter what governments or companies are paying.

[asp]

to continue, why would private debt be considered riskier? Because companies & individuals can go bankrupt. Governments can't, or are much less likely too.

It is much easier for governments to raise revenue through taxation then for a company with excessive debt to raise revenues through sales.

[Kosta]

Nick: I'm thinking that the interest rates on private loans are approximated by the source gov't/central bank interest rate plus some private default/liquidity risk premium. In your first example, if there are barriers to interprovincial lending, then private loans would be sourced from ?? Are the loans sourced from the BOC based on federal debt? Or if the lending barriers are significant enough, could those private loans be based on provincial debt ?? If the latter is true, then won't the rates of each province's private loans be based, in part, on that province's default risk? But presently, the system is such that the BoC funds all banks in Canada, levelling private interest rates across the country.

For the Eurozone, I think the pre-crisis system was for domestic banks to get their funds from their country's central bank. Domestic rates would vary from country to country based on the credit risk of each country (with cross-border lending levelling the rates to some degree). Post-crisis, the ECB stepping in and ignoring risk as you point out -- the ECB is acting like the BoC and funding all banks, thus levelling private interest rates across the Eurozone.

I do wonder if the ECB's actions are sufficient to completely level rates though.

[Nick Rowe]

asp: a government that can print money, and has debts in that money, can't default, unless it prefers default to inflation. That's the normal reason why Federal debt always has a lower yield than private debt in the same currency. If the government pays its debts through inflation, then private debts are also paid through inflation at the same time. But governments that can't print money, or who have debt denominated in a currency they can't print, are really not much different from private borrowers. Sure, they can tax, but there's usually a limit, either political or economic, to how much they can tax. So in some circumstances private debt could be safer than government debt.

Patrick: (I think you mean the demand curve is *more* steep than it otherwise would be.) If demand curves facing a firm were inelastic (even if not perfectly inelastic) then revenue would rise if they raise price, and costs would fall, so profits would rise. So why aren't prices infinite already?

[Nick Rowe]

Kosta: If I think that a private borrower is safer than a provincial government, and if they had the same yield, I would buy private bonds, not provincial government bonds. So would everybody else. Who would buy provincial government bonds with higher risk and the same yield? So prices on private bonds would rise, and yields fall, relative to provincial government bonds. They could only have the same yield in equilibrium if someone were ignoring the risk differential.

[Nick Rowe]

And that "someone" would end up holding *all* the provincial government bonds.

[jsalvati]

In the face of things like this (and it seems as if there are many), why do economists still talk about AD as opposed to using some more basic ideas (demand for money ect)? Talking about AD seems like it's just begging for confusion.

[Patrick]

Nick: Yes, more steep and not infinitely so (I should refrain from commenting on econ before the first cup of coffee has taken effect!).

[JP Koning]

When a provincial government goes bankrupt, the province's largest purchaser of labor and goods goes into receivership. The province has accounts payable to local businesses for services/labour/goods previously rendered. Will these go unpaid or will bondholders get first dibs? This uncertainty will lead lenders to ask businesses who do most of their work for the province to pay higher interest rates to compensate. A local business that doesn't do much work for the province, nor does much work for those who do a lot of work for the province, is probably safe.

This isn't about currencies or borders. The more exposure a business has to a defaulting entity, the greater that business's risk of default, and the higher the interest rate required to compensate.

[Nick Rowe]

JP: good point. But it wouldn't mean that a 1% increase in government bond yields would cause an equal 1% increase in private yields. And it could still allow that some private loans are safer than government loans, and should have lower interest rates.

[Leigh Caldwell]

I suspect that not all private bonds are equal...or at least, some are more equal than others. What's more, I think not all sovereign commitments are equal.

My suspicion is that eurozone countries have carefully delineated their liabilities. The Irish government, for example, has at least two kinds of debt: government bonds, representing formal sovereign commitments; and guarantees of bank liabilities, representing a political commitment to stand behind the debts of their banks.

If the government were really to run out of money, you can bet they'd abandon the bank guarantees before defaulting on their own bonds. This would be much easier to present to the markets as "not a real default", thus allowing the government still to borrow in future.

If this hypothesis is correct, we should see different correlations in different parts of the private sector. The spreads on bank debts would be highly correlated to those on government debt - indeed they would be magnified, as a small rise in risk of Irish default would translate into a much larger rise in the risk of Anglo-Irish Bank default. But the spreads on the bonds of an Irish industrial company should have a much weaker link to the creditworthiness of its government.

Of course there will still be some link, since Irish factories are presumably partly funded by Irish banks; and thus a banking crisis would affect industry's ability to repay debts too. It would be possible, but not easy, for Irish Potato Mining Ltd to refinance via a German bank after the crisis.

So with a given rise in Irish government spreads, we'd expect to see a smaller rise in Irish non-financial interest rates, but a larger rise in Irish finance sector interest.

How does this apply to the Canadian case? Are there Canadian provincial banks? Within the EU there are few genuinely transnational companies, either in or out of the finance sector. I suspect Canada has a much more integrated national market.

[Phil Koop]

JP's point is the second one that occurred to me. The first one was along the same lines: European companies sell into an international goods market and borrow on an international capital market. So on the one hand, their revenues are only partially dependent on domestic considerations and on the other, the ability of a domestic government to re-denominate corporate debt is extremely limited. Any foreign assets could be seized in judgment. Even when a company can avoid legal consequences, it may choose not to default in order to avoid reputational damage. So, while the comparative credit sensitivity signal for euro exit you propose is plausible, it would require a lot of work to disentangle it from other possible attributions. I doubt you would be much damaged by just peeking at the data.

[Andrew F]

What's the game here? If the markets assume that private borrowers will do a partial default if the government does, why shouldn't they/their government do just that? If they are already assumed to behave that way, one might as well take the benefits of it since you pay the costs regardless.

Is there a way to credibly promise not to have private borrowers default at the same time?

[Nick Rowe]

Leigh and Phil: OK. So if interest rates on some government-guaranteed bank debts should rise more than one-for-one with the risk of government default (Leigh), and some private firms with seizable foreign assets should rise less than one-for-one (Phil), it would indeed be difficult to disentangle the signal of an exit from the Euro from the other noise in the data.

[Nick Rowe]

Andrew: You lost me (I think).

The greater the probability of default, the higher the interest rate, and so the greater the incentive to default, and so the higher the probability of default? Is that what you are saying?

[JP Koning]

Ok, given your assumptions I see what you are getting at Nick.

I can see this picture too: Say that the odds of a Greek government default is approaching 100% (along with a leaving-the-Euro scenario). Any number of Greek companies operate overseas and would continue to earn hard currency ie. non-drachmas. There's no way these firms could re-denominate their foreign debts. They may choose to continue paying local obligations in Euros. Local bankers will have already protected recent loans by indexing them to their Euro equivalent. Given all these factors, firms would be a much better credit risks than the government who - in a default/no-euro scenario - will *only* pay in non-indexed drachmas. So lending rates to diversified Greek firms will probably still be lower than government rates as a default/drachma scenario becomes more likely.

[Determinant]

I can see a big difference between A and B and I'm surprised nobody has brought it up yet. In B the provinces have recourse to the Government of Canada, with a single Minister of Finance and Central Bank in charge. The Federal Government has significant taxing and redistribution powers and uses them freely.

In A there is no federal government and no clear rules on redistribution.

In Canadian history there has been a single provincial default, that of Alberta in 1936. They paid half the coupon interest rate on their maturing bonds until 1945. The Social Credit government had a long-running feud with Ottawa over money and banking and Ottawa directed the Lieutentant Governor to disallow several pieces of provincial legislation.

Manitoba and Saskatchewan also approached default but they were bailed out by Ottawa.

This whole sorry mess was one of the principal reasons for the Rowell-Sirois Commission.

If a province defaults, it isn't bankrupt. It can't be sued by creditors due to Sovereign Immunity and can't be placed in bankruptcy. The Feds also can't just jump in and take things over, that's against the Constitution. The debt simply remains unpaid and the bondholders are left holding the bag.

[JP Koning]

Actually, Phil beat me to the punch on that one at 2:42.

[Nick Rowe]

Determinant: if Ottawa is expected to bail out a provincial government, that will reduce yield spreads across different provinces, compared to yield spreads across Eurozone governments. But that can't be 100% a sure thing, or else all Canadian provincial debt would yield the same (and if there were liquidity differences, provinces with bigger debts should presumably have lower yields). But what about the private-government yield spreads?

[Determinant]

The implied bail-out between Ottawa and the provinces isn't mandatory, it's discretionary. Which accounts for part of the yield difference, as does the fact that there is a residual default risk without recourse to underlying assets. So on that account you're right on, Nick. It's legal but not mandatory.

The fact is that nobody really thought in terms of default when the Constitution was signed, in fact most of the debts of the Province of Canada (future Ontario & Quebec), New Brunswick and Nova Scotia were signed over to the new Government of Canada in 1867. That was the pattern right up until 1949. Two-thirds of Newfoundland's public debt was assumed by Ottawa when it entered Confederation, in recognition that pre-Confederation Newfoundland had to carry on the duties both of the Government of Canada and those of a province.

In fact the solution floated by the Rowell-Sirois Commission and pursued by Ottawa after 1945 was that Ottawa would take over all provincial debts and in return receive 100% of personal income tax, corporate income tax and estate duties. Rates would be uniform across Canada and the provinces would receive a transfer. This is similar to what transpired in Australia, actually. The problem was that the provinces, particularly Ontario and Quebec were loathe to give up their fiscal autonomy and thereby severely curtail their political autonomy as well. As a result, the deal fell apart.

As for your theory on Euro private-government yield spreads, I presume you are correct. I'm more of a historian than an theorist.

[The Money Demand Blog (123)]

Monetary policy is much more fragmented in Eurozone than in Canada, this is the main reason why A is true. Leigh is right, geographical distribution of Eurozone AD is heavily influenced by the fiscal backing provided by member states to their national banking systems (private sector bond markets are relatively unimportant). At this particular moment this effect is softened by ECB's refinancing auctions with full allotment, but full allotment liquidity auctions will be discontinued in the future, this could cause further regional divergences in AD.

[happyjuggler0]

Answer these questions and you should see the light:

1) Why does the government default on the debt? What happens to government revenues and expenditures during a recession?

2) When the government defaults on its debt to local banks and citizens, what happens to their ability to repay their own obligations?

2a) What then happens to the economy in general, affecting those who had no loans to the government?

3) If the government defaults on its debt, presumably it had a budget deficit that it still has to close. How does it close that gap?

3a) How likely are citizens to riot (a la Greece and France) in response to such budget balancing that directly affects them, and what does that do to the economy?

[Nick Rowe]

It ate my comment! Test.

[Nick Rowe]

Trying again:

TMDB: why is Eurozone monetary policy more fragmented than Canadian? Because their banks are more "provincial", doing most of their borrowing and lending within national borders, and are all capital constrained, and insolvent except for support from their national governments? Did I understand you correctly? OK.

happyjuggler: sure, but that mechanism linking government with private default would only give an imperfect correlation. And it wouldn't prevent some private borrowers being safer than governments, so some private interest rates should be lower.

[Ian Lee]

Nick,

From your first post, you said:

Does that sound right?

(I haven't looked at interest rates on private loans across Eurozone countries, nor across Canadian provinces. Partly because I'm lazy, and incompetent at getting data; and partly because I want to state the theory first before peeking at the data, to avoid bias. Data nearly always give a fuzzy picture, and it's best if the person looking at the data isn't wedded to a particular theoretical interpretation.)

I posit the following concerning only the Canadian banking system, and which may provide some partial insight.

The Big 6 Canadian banks control approximately 95% of bank assets in Canada including consumer lending. Trusts, credit unions, caisees have a tiny percentage of the loans market (less than 5% I believe).

As a former Branch Manager, Consumer Loan Manager, Mortgage Manager and Commercial Credit Officer over 9 years in the 1970s and 80s, while the local lending officer had discretion within a band or range of rates, the band was set by Head Office in Toronto - for the ENTIRE country - based on minute to minute changes in cost of funds monitored like a hawk by the really sharp economists that work in the HQ Treasury Departments.

How did we know that? Because announcement of a change in the intere4st rate band (for consumer loans or mortgage loans or revolving lines of credit etc) were published in writing as a Policy and Procedure Manual revision with page number, date of revision and region(s) to which it applied.

Restated Canadian bank lending market policies concerning interest rate pricing has been "national" i.e. not regional or local, for as long as I know.

Shades of the Harvard Business historian Alfred Chandler who argued that Sears, GM and Dupont were the first national companies that created national markets to replace regional markets.

Thus, provincial bond rates or default risk would have no bearing on the 6 banks interest rate determination. Note these 6 banks are vastly vastly larger than most provinces (each bank currently in the ballpark of about $500 Billion to $1 trillion in assets). And we controlled for risk of over selling to a small number of customers by imposing loan covenants that capped the max share of sales annually of each customer to e.g. 5%.

But the banks were monomaniacal about the calculation of cost of funds (NIE-NIX ratio and all that) - in setting the interest rate bands.

I hope this provides some small illumination to a part of your puzzle.

Ian

[The Money Demand Blog (123)]

Nick, yes. Cost of bank capital in the different Eurozone countries is different because every member state taxes/subsidizes bank capital differently, and the amount of tax/subsidy is correlated to sovereign default risk. I value Finnish and Danish bank deposit insurance more than I value Portuguese deposit insurance. Danish AD is more correlated to Eurozone AD than Greek AD is, even though Denmark is not a member of the Eurozone. Denmark has a 1% wide peg to Euro and ERM-2 agreement with the ECB, and taxation/subsidization of bank capital in Denmark is quite close to the Eurozone average.

[Nick Rowe]

Ian: Thanks. Yes, that does indeed provide some illumination. You have confirmed B is totally false (at least in Canada), as I suspected.

And TMDB confirms that A seems to be true.

[Just visiting from Macleans]

Ian: Thanks. Yes, that does indeed provide some illumination. You have confirmed B is totally false (at least in Canada), as I suspected.

Ahh, not so quick. At the risk of demonstrating/confirming my ignorance of macro, allow me to chime in on Ian Lee's observations during the 1970s/1980s before when most of your/his students were born.

There was a major local correction in Alberta in the 1985/1986 when many homeowners, who qualified for mortgages under apparently national criteria, walked away from their mortgages when their market value was below the cap owed to the banks. I think the laws were subsequently revised to prevent homeowners from walking away from their mortgages.

But, if you were a local branch loans officer in say Edmonton in 1986, looking to get ahead in the bank (and eventually land a prima job on Bay Street) with a nationally set interest rate, what would you do? Well, I would cut back on marginal loans that qualified on a national standard (say 20%), and make sure that the loans I approve met a higher means test (say 30%). True, the national loan rate has not changed. But who qualified effectively has.

Is what happened in the 70's/80's applicable today? I dunno. I'd be cautious in accepting that anecdote today.

[Alan Rai]

Nick,

I think you touched on the issue -- the correlation. The same macroeconomic forces that lead governments to default may also lead to distress by private borrowers -- cyclically weak AD (induced by tight policy); or structural, 'recalculation'. The key is that the forces must be 'systemic'; hence not just limited to 'idiosyncratic' provinces or regions.

This is a problem for countries even with sovereign m/p; adding in a new currency and/or large foreign borrowing by private/public borrowers also makes this a bigger problem.

Alan

[Canadian Drugs]

If the government pays its debts through inflation, then private debts are also paid through inflation at the same time. These all are great to know about it.