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Why Some European Countries and Not the U.S.?

These days it seems it is just a matter of time until we hear about the next euro zone country whose interest rates on sovereign debt will start soaring. What started with Greece, Portugal, and Ireland has since spread to countries of greater economic importance such as Spain and Italy. The United States is dealing with serious debt issues, too, but while Spain and Italy face increased borrowing costs, interest rates on U.S. government debt are at all-time lows.

Figure 1. Ten-Year Bond Yields

Why are interest rates on U.S. sovereign debt so much lower than those of Greece, Italy, Portugal, Ireland, and Spain? (For simplicity we will call these countries the euro zone periphery or EZP.) The two most frequently cited possibilities are substantial differences across countries in either the ratio of sovereign debt to GDP or in the countries’ growth prospects. Neither possibility seems to explain the sovereign debt spreads between the EZP and the U.S.

The sovereign-debt-to-GDP ratio could cause the interest rate spread if it were much smaller in the U.S. than in the EZP countries. While that is true for most of the EZP countries, Spain has a smaller debt-to-GDP ratio than the U.S. and Ireland has one similar to the U.S. The amount of debt outstanding, however, may not tell the whole story behind the interest rates. In particular, two countries may have the same debt-to-GDP ratio and have very different immediate financing needs. When we look at financial obligations over the next few years, or at the average debt maturities, we see very little difference between the U.S. and the group of EZP economies experiencing large increases in interest rates.

Gross Financing Needs (Percent of GDP)

2011 2012
Maturing debt Budget deficit Total
financing need
Maturing debt Budget deficit Total financing need Average years to maturity
(as of September 2011)
Debt to GDP ratio
United States 17.6 9.6 27.3 22.4 7.9 >30.4 5.1 72.6
Greece 15.71 8.0 23.7 9.6 6.9 16.5 6.9 144.72
Italy 18.5 4.0 22.6 21.1 2.4 23.5 7.2 117.2
Portugal 16.1 5.9 22.0 17.9 4.5 22.3 6.0 88.7
Spain 13.4 6.1 19.6 15.4 5.2 20.6 6.2 48.7
Ireland 8.7 10.3 19.0 5.3 8.6 13.9 6.2 78.0

1. Greece’s maturing debt assumes 90 percent participation in the debt exchange.
2. Eurostat calculation.
Source: International Monetary Fund, Fiscal Monitor, September 2011.

The spread might also arise if the growth outlook is better for the U.S. That is true, for the most part, but in order for future growth to help the fiscal situation, it needs to lift future revenues and reduce future deficits. Looking at deficit projections, anticipated U.S. growth does not seem sufficient to bring down the U.S. deficit in comparison to the deficits of the EZP.

Projected Government Balance as a Percent of GDP

2011 2012 2013 2014 2015 2016
United States −9.6 −7.9 −6.2 −5.5 −5.6 −6.0
Greece −8.0 −6.9 −5.2 −2.8 −2.8 −2.8
Italy −4.0 −2.4 −1.1 −1.1 −1.1 −1.0
Portugal −5.9 −4.5 −3.0 −2.3 −1.9 −1.7
Spain −6.1 −5.2 −4.4 −4.1 −4.1 −4.1
Ireland −10.3 −8.6 −6.8 −4.4 −4.1 −3.7

Source: International Monetary Fund, Fiscal Monitor, September 2011.

The size of the 10-year government bond spread between the U.S. and the EZP is pretty significant. There are several other reasons that might explain why rates are still so low in the U.S.

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, 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.

In the euro zone it seems the commitment devices set forth by the Maastricht Treaty limiting the national governments’ debts and deficits lacked bite and ultimately failed, shattering the credibility of some of the member countries’ governments. In contrast, the market seems to think the U.S. government can solve its debt problems, which are mostly tied to entitlements (see this Commentary). This vote of confidence should not be squandered.

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