Inflation

macaque_2

A couple of years ago, we saw Iceland's interest rates forced up. This has been followed by Ireland, Greece, Spain, Portugal and Italy. Is the market trying to tell us something?

When people lend money, risk is priced into the borrowing rate. In the case of Italy and Greece, they are borrowing Euros and the Germans with their anti inflation agenda, are resisting QE. In this case, lenders will be paid back with good quality currency but it may only be at 70 cents in the Euro.

Britain is solvent (at the moment) but lenders to HMG are guaranteed to lose 5% of their capital in a year through inflation (and possibly rising). If I was a lender, I would want inflation plus, not inflation minus. The government have also announced a £50b infrasturcture project. If I was a lender, I would not like this.

Is this analysis right or am I missing something? Are we going to wake one of these days to a 'Norman Lamont' moment?

michaels

We could be like Italy with multiple equilibria - given low rates we can pay the interest so the default risk and risk premia stay low.

But if rates were higher the interest bill might become unaffordable leading to higher rates still to cover the default risk and so on spiralling out of control.

However unlike Italy we are in a position to monetize the debt so default would be as you say via inflation and a run on the currency.