Politically Informed Yields
So much, then, for the basic elements of credit markets. Now to enter into its political dimensions, it will be necessary to dwell further on the matter of yields. This is where the relationship between governments and the markets starts and it is where the relationship evolves into its most consequential manifestations. Yields are the major rendezvous point between the two parties. Yields are, after all, the price that governments negotiate with the market for credit. Though both benefit in coming together for a loan, the continual haggling over price can put a strain on the relationship. A sense of dependency can arise that allows one side to exploit the other. Feelings of ill-will and recriminations may easily be triggered when one of the parties reneges on their promises or demands too high a price to continue the relationship. Each side tries to do the best it can for itself by wielding the leverage at its command.
For the markets, that leverage consists in the fact that they hold the money that the government wants; for governments, it consists in the fact that they can coerce people, including those in the markets, to get whatever they want. How one sees this contest depends on whether one believes the state or the markets ought to serve as the ultimate organizing principle of economic life. Those who lean toward the state will find it objectionable whenever the markets set the yields too high for governments to borrow. Those who lean toward markets will find it presumptuous for governments to expect that they can borrow at whatever yields suit them.
Settling this debate involves answering the following: do the bond markets tend to establish the right yields for government bonds? Or do they systematically get the yield wrong? A great deal of evidence indicates that the bond markets more often get it right than wrong. Let me begin with a recent example, Greece. The markets first gave warning of a problem there in the fall of 2008, about two-and-a-half years before that country’s debt crisis first hit the acute stage in the spring of 2010. This can be seen in Fig. 4.2, which depicts the yield spread between Greek ten-year bonds and Germany’s ten-year bonds, known as bunds. The reason the comparison is made to Germany is that its bonds are deemed to be the safest in Europe. So the difference between its yields and those of Greece represent a risk gauge of the latter’s debt.
Notice how the spread suddenly lurched up in late 2008 and early 2009. It then declined somewhat throughout 2009, though never going back to the previous range near the zero level at which the spread traded prior to the fall of 2008. Then, beginning late in 2009, and accelerating into early 2010, the Greek-German bond spread moved dramatically higher. It was in May 2010 that the Eurozone governments finally came to terms with what the markets had been signaling and arranged a bailout. That did not stop the spread from widening further into 2012. The bond market thus eyed the prospect of a second bailout for Greece, which indeed was finalized in February 2012. From there, the yield spread steadily declined, though that reflected the ECB’s pledge, enunciated by Mario Draghi in July 2012, to do
Fig. 4.2 Yield spread, Greece ten-year bonds versus German ten-year bunds, 2008-2015. Source: ECB
whatever it takes to save the Euro—more on that in Chap. 7. In any event, the markets took Draghi’s pronouncement to include a willingness to purchase Greek bonds. Later, the spread began to rise again in the second half of 2014. The bond market was alerting the world that a new round of trouble was on the horizon. That came true in January 2015 when Alexis Tsipras was elected to lead Greece on a promise to renegotiate the country’s debt.
Well before Greece’s recent travails, bond yields have proven themselves politically and economically insightful. One can go back to the decade after the French Revolution, the period between 1790 and 1799. At the time, Britain’s bonds, known as the consols, were considered the benchmark for safety. Over that decade, the yield spread between French long-term debt and Britain’s consols averaged 9.5 %. Such an elevated level corresponded to the political volatility that is universally recognized as having marked France in the aftermath of its revolution. The French-British bond spread then declined to an average of 3.9 % in the 1800-1809 time frame. This squares with the prevalent notion that Napoleon brought a semblance of order to revolutionary France. Yield differentials also widened during the 1848 revolutions, which impacted Continental Europe more than it did Britain. Accordingly, French yields went from an average premium of 0.85 % versus consols in 1847 to 2.46 % in 1848 and 2.74 % in 1849.
Government bond movements also illuminate World War II and the events leading up to it. Key turning points are discernible in the historical yield data. One can note statistically significant changes occurring around the February 1939 German invasion of Czechoslovakia. The same goes with the official start of hostilities in September 1939, the Japanese attack on Pearl Harbor in December 1941, and the subsequent entry of the USA into the war. Yields reacted as well to the D-day invasion of Normandy in June 1944, and the final collapse of Germany in April 1945. In line with the consensus view that the blame for World War II rests with Adolf Hitler and the Nazis, an index of European government bonds traded in Switzerland, then the safest place to trade sovereign debt, shows an uptrend in yields from 1933, when the Nazis attained full control of the German state. Considering that US government bond yields steadily fell during the 1930s and 1940s, this means that European-US yield spreads generally rose. 
Interestingly, combing through the historical yield data lends further support to an observation made in the previous chapter. Yields make it clear that the gold standard prevented governments from inflating away the value of their debt. Figure 4.311 displays the yield spreads on long-term government debt for the USA, France, Germany, and the Netherlands relative to Britain’s consols from 1870 to 1913. The trend is manifestly down. Evidently, as nations demonstrated a commitment to gold by their continued adherence to it, bond investors progressively demanded less of a risk premium to buy their debt. The link to gold, after all, meant that countries were restrained from harming bond holders by reducing the purchasing power of the money still owing them. It should be added that investors were also safeguarded from adverse
Fig. 4.3 Selected yield spreads versus British consols, 1870-1913. Source: Sidney Homer and Richard Sylla; Measuring Worth
moves in FX rates that would affect any international bonds they might have in their portfolios. For if a set of national currencies are tied to gold at a set rate per ounce, it logically follows that the price ratios between those currencies will also be fixed.
What is especially remarkable about the narrowing of spreads is that political risk was obviously perceived to be low, if not diminishing, heading into World War I. That epochal conflict, with all its attendant costs, appears to have come as an utter shock. As such, the yield data belies the oft-expressed view among historians that in the years leading up to August 1914, tensions were simmering between the European powers because of intensifying nationalism, imperialist conflict over colonies, and an escalating arms race. One could, of course, counter that the markets were irrationally sanguine. But in making such a judgment, we have to be mindful of that deep-rooted bias by which the benefit of hindsight makes us all too eager to believe that something could have readily been predicted. Lewis Frey Richardson famously discovered that, statistically speaking, the start and duration of wars are random events. 1 2 Based on what the markets factored in prior to World War I, Richardson is correct. 
-  European Central Bank, “Long Term Interest Rates”, http://www.ecb.int/stats/money/long/html/index.en.html
-  Figures presented here based on historical yield data provided by Sidney Homer andRichard Sylla, A History of Interest Rates (New Brunswick, NJ: Rutgers University Press,1991). See tables at 156-157, 172, 195-196, and 222-223.
-  Bruno S. Frey and Marcel Kucher, “History as Reflected in Capital Markets: The Case ofWorld War II”, The Journal of Economic History 60, no. 2 (2000), 468-496.
-  Sidney Homer and Richard Sylla, A History of Interest Rates, 352.
-  Measuring Worth, http://www.measuringworth.com/
-  Lewis Fry Richardson, Statistics of Deadly Quarrels (Pacific Grove, CA: Boxwood Press,1960).