European Affairs

Spring 2004

 

Finance
Europe Should Protect Itself from U.S. Interest Rate Contagion
By Gerd Häusler

 

The conventional wisdom is that economic policy affects capital markets, either directly through interest rates or indirectly through its impact on economic growth and corporate earnings, which in turn affect equity markets. Another way of saying this is that economic fundamentals influence financial markets.

This is still true. But I would like to offer another view that I shall exaggerate a little in order to be provocative. In the Transatlantic relationship, and also to a lesser degree in other regional relationships, it seems that the direction of influence is being turned on its head. Capital markets increasingly affect the real economy, rather than the other way around, even across the Atlantic.

What we are seeing is an increasing correlation of market interest rates between the United States and Europe, even though economic cycles still diverge. Not only do European stock exchanges take their cue from the New York Stock Exchange, but bond yields on either side of the Atlantic have moved much closer together over the past ten years or so.

The reason is that as capital markets become more integrated, international investors react quickly to price signals emanating from the United States, the world's largest economy and capital market. Higher U.S. bond yields usually reflect stronger U.S. growth. And when the United States is expecting higher growth, European yields also tend to rise, because investors think that a stronger U.S. economy will stimulate growth in Europe. There is an instantaneous arbitrage opportunity between U.S. and European bond yields.

Most fundamentally, however, capital markets are undergoing a profound structural change. Increasingly, financial markets draw on one global pool of capital, and any market participant can tap into it directly, without having to go through banks any more. Banks, insurance companies, mutual funds, governments and households can access capital markets either directly or indirectly, through pension funds, or trade risk exposure directly with other market participants.

The dominant role of banks as intermediaries in capital transactions has diminished, meaning that bond yields are becoming more relevant pricing instruments than bank loan interest rates. Bond rates also have stronger linkages than bank rates across national borders and across the Atlantic. Bank rates are still more reliant on rates set by the national monetary authorities, whereas bond yields tend to react more readily to other influences as well.

Transatlantic capital flows are increasingly driven by portfolio considerations. The closer we move to a single pool of capital, as we are continuing to do, at least in the very advanced world, the more such capital will carry a single price tag.What is the implication of all this for policy coordination across the Atlantic, and more broadly among the G-7 countries?

The evolution toward a global capital market is creating a natural center of gravity for interest rate determination in Washington, the modern Rome. International interest rates are increasingly driven by the U.S. Federal Reserve, which is today playing a global role similar to that played on a regional basis by the German Bundesbank in Europe in the late 1980s and early 1990s. Central banks, however, have a national mandate, with domestic objectives enshrined in their legal statutes. The Federal Reserve pursues primarily domestic aims in setting U.S. monetary policy, just as the Bundesbank did 15 years ago.

Just as it did in Europe, this may pose problems for countries that are at a different stage in the business cycle or, more fundamentally, have a significantly different growth potential from the leading country, in this case the United States. Today, such problems face a number of European countries, which have failed to reform their economic structures. As a result, countries outside the United States see a greater need for policy coordination, given that the repercussions of U.S. monetary policy spread far beyond America's borders. And this applies not only to Europe, but perhapseven more so in emerging markets.

In the early 1990s, the Bundesbank's interest rate policy was particularly untenable for the rest of Europe because of the European Union's fixed exchange rate regime, which did not allow other countries any room for maneuver. In today's Transatlantic relationship, the restrictions are not that stringent, given the flexibility of the dollar/euro exchange rate. Nevertheless, the correlation of high Transatlantic interest rates restricts Europe's room for pursuing an independent monetary policy, especially at times when rates are rising.

The European Central Bank, of course, can set the interest rates it deems appropriate, but market rates do not necessarily follow. At least outside the United States, market rates are much less swayed by national monetary policies, than in the past, but obey the laws of a global capital pool. Although prospects for economic recovery in Europe remain uncertain, the growth differential between the United States and Europe seems to be widening again, as the United States moves into another upswing. If the strong U.S. growth scenario drives up U.S. bond yields, and European bond yields follow, Europe may come under pressure to use other policy methods to stimulate growth.

Fiscal policy, however, has clearly been largely exhausted, which leaves structural policy as the only option. For some European governments it will be politically difficult to press for serious structural reforms ˇ meaning that Europeans are going to have a hard time catching up with the United States. Nevertheless, the Europeans will have to find a way to implement needed structural reforms both as a means of stimulating their economies and to raise their growth potential in the medium term, given that monetary policy is now such a weak lever.

There is, of course, one way to limit the consequences of these Transatlantic interest rate correlations. Europe may be able to gain some protection from U.S. interest rate contagion if it continues to create its own highly efficient capital market, similar to the market the United States has established over the past few decades. I hope that the Europeans have clearly understood this message, and that they will press forward with the necessary actions as soon as reasonably possible.

Gerd Häusler is Counselor and Director of the International Capital Markets Department of the IMF. He was previously Senior Advisor to the Deutsche Börse in Frankfurt, and before that Chairman of Dresdner Kleinwort Benson in London. He was also a member of the Board of Managing Directors at Dresdner. He spent twelve years at the Bundesbank, where he held a number of positions including Member of the Board of Managing Directors and of the Central Bank Council.