National balance sheets and the crisis Recently, when events have centred on the euro area, the focus has been on the risk of sovereign default. The underlying issue is the cumulative loss of competitiveness of some economies, and the consequent strains in government balance sheets resulting from their attempts over the years to use fiscal policy to sustain growth. A look at Spain’s external balance sheet reveals (net) liabilities of around 100% of GDP (Chart 1). Italy’s net external liabilities are, perhaps, rather smaller than that (Chart 2). But in terms of total government debt, Italy’s new administration inherited the greater burden. Put those two facts together and it becomes clear that Italy’s fiscal problem is partly about the distribution of debt and resources within the country. Japan is, perhaps, not dissimilar. Go back four-five years, to the beginning of the crisis, and the problem was the mortgage obligations of US households – subprime households in particular were hugely over borrowed. The commercial real estate sector too. Defaults there triggered the crisis. Every set of defaults and problems around the world has reverberated through the UK, due to London’s role in intermediating international capital flows. We have one of the largest gross external balance sheets (Chart 3). Although much of it is accounted for by foreign banking activity, the City is not an entrepôt. UK banking is linked to the wider City’s fortunes via complex counterparty-credit exposures and investments.
The spot nominal interest rate on a ten-year zero-coupon government bond can be thought of as the average of the short-term interest rates expected to prevail over the ten year period, plus a term premium (which is often thought of as compensating investors for uncertainty around those short-term interest rates). Comparisons between yields on government bonds of different maturities can be used to identify a sequence of forward rates (ie the expected short rates at each point in time plus a forward term premium associated with that maturity). Using the information from the yields on inflation-linked government bonds, expectations of nominal short-term interest rates and forward premia can be broken down further into the expected future inflation rate (and an associated forward inflation term premium) and the expected future real interest rate (together with the associated forward real term premia), equation (1). ftnominal(n) = (Et[rt+n] + RPtReal) + (Et[πt+n] + RPtπ) ; where ftnominal(n) denotes the n-period ahead forward interest rate prevailing at time t; Et[rt+n] and Et[πt+n] the expectations for the real interest rate and the rate of inflation at that point and RPtReal and RPtπ the corresponding forward real and inflation term premia. In principle, then, there are two broad channels through which a decision by monetary policy makers to change their policy rate could affect longer-term interest rates, such as the 10-year government bond yield. First, the decision could change market participants’ expectation of either real interest rates or inflation. It is worth noting two standard bedrocks of monetary economics here.