Interest is usually defined as the cost for the use of money. But that's not precisely correct. Interest is the cost of using a particular kind of money—the money a lender expects to get back. Obvious? Maybe, but unless we clearly grasp what allows this crucial expectation to persist, we will fail to understand why interest rates in some countries, including the US, have been so low for so long, while those in other places are sky high.
In theory, the movement of interest rates is a purely monetary phenomenon. Money has no intrinsic value; it is simply a means to an end. Consider this decision matrix: You want to buy a refrigerator. It costs $1,000. You can buy it now or a year from now. But, if you wait a year, will it still cost $1,000 or will it cost more? If you decide to buy the refrigerator later and invest the money in the meantime, you will have to earn enough interest to cover the increased price. Of course, it's impossible to know today what the refrigerator will cost 12 months from now, so you will have to make a guess.
That's what the $31 trillion market for US government bonds is doing all the time. As investors and speculators buy and sell government bonds of various maturities, they are making their best guess about the value of money when the bonds mature. Investors require a high rate of interest when they believe money will have less purchasing power in the future. These days, investors believe that money will retain its present value over long periods of time. That's why interest rates are low. In theory.
In practice, there is something deeper going on. At best, the world is struggling through a very weak economic recovery. At worst, we may be on the brink of an even more severe global recession. In a time of such uncertainty and fear, shouldn't money be expensive to borrow, not cheap? Imagine that, instead of being the buyer of a refrigerator, you were the owner of the company that makes the refrigerators. As more potential customers deferred their purchases, you might need to borrow money to keep your business going. If you could borrow at all, you would find the cost—that is, the rate of interest you had to pay—much higher than if times were good and you were selling refrigerators like hotcakes. The reason, obviously, is that your lender is taking a bigger risk, which requires more compensation. You might not be in business when the time comes to repay your debt.
The same dynamic is at work for countries. The table shows the yield for 10-year government bonds as of June 8. The buyer of a US, a Swiss, a Japanese, or a German government bond does so with virtually complete confidence that, at maturity, that government will repay its obligation. Brazil? Portugal? Greece? Not so much.
What is the basis for this confidence? It is not a country's wealth. Neither Japan nor Switzerland has much natural wealth. Russia, which has more natural resources than any other nation, doesn't issue long-term debt because it would be prohibitively expensive.
Nor does a country's history guarantee confidence. Greece was the world's first democracy. Spain and Portugal once owned all of South and Latin America.
No. Investors have confidence in nations where the rule of law is fundamental, pervasive, and transparent. The rule of law—that is, basic honesty, fair-dealing, and consistent moral standards—is the bedrock of the American economy. Because investors have the confidence to loan our government long-term money at favorable rates, our country has the inestimable benefit of Time to resolve economic problems without being crushed by either hyperinflation or draconian austerity.
In a recent paper, "Money, Politics, Power: Corruption Risks in Europe," Transparency International reports that, while 19% of Danes consider corruption a major problem in their country, 98% of Greeks consider it a major problem in theirs. The perception is grounded in fact. The report notes that "Greece, Portugal and Spain highlight in particular that inefficiency, malpractice, and corruption are neither sufficiently controlled nor sanctioned." It is hardly a coincidence that Denmark pays 1.23% to borrow for 10 years, while Italy, Spain and Greece pay the highest rates in Western Europe.
We won't become like Greece just by borrowing a lot of money. If we ever become like Greece, it will because we abandon the rule of law.