The chart below represents one of the most important charts for European financial markets in 2011, perhaps even for global financial markets*:

*Lou Basenese, Seeking Alpha

This chart may be broken into three phases:

In the pre-1999, pre-euro introduction phase, each country had its own interest rate on government bonds. Even before the euro became reality, interest rates began to decline and converge.

In the second phase, after introduction of the euro in 1999, it took just a year or two for interest rates to fully converge. For six or seven years, interest rates throughout the euro zone fluctuated together and were identical.

Finally, after Lehman went bankrupt in 2008, interest rates began diverging again and by 2011 had totally scattered. Notice that interest rates for countries like Germany went even lower, while Greece’s and Portugal’s interest rates jumped dramatically.

So what happened here? How does one explain the above chart?

In the first phase, rates converged because market participants believed that the advent of the euro would the risk of government debt for countries like Greece and Portugal. By the second phase, the complete concordance of interest rates (e.g. identical rates for Germany, Greece and Portugal) implied that market participants believed that the European Central Bank (ECB) would stand fully behind the debt of every country (e.g. even if there were a default in Greece or Portugal, the ECB would not permit investors to lose money).

After the Lehman debacle, interest rates diverged when it became increasingly evident that the European Central Bank did not have the monetary resources, and the German government did not have the political consensus or will, to save and hold harmless investors in bonds of all Euroland countries.

One might say that countries like Greece were “free riders” during the 2001-2008 period. Because their cost of debt was based on a false assumption, namely that the ECB and ultimately wealthier countries like Germany and Italy would come to the rescue, they could go on a borrowing binge, and not pay the full price of their profligacy. When their interest rates began to triple or quadruple, they entered a period of great financial distress, and wealthier EU countries had to come to the rescue.

The “scatter” effect has also been augmented by a diminution in interest rates in Germany, as investors in Europe and the world over have experienced a “flight to quality.” Demand for German government bonds increased, driving rates down.

The graph also underscores the importance of confidence of financial markets. The confidence of financial markets can make the difference between high interest rates or low interest rates on government debt, which in turn can make the difference between solvency or insolvency, where debt is denominated in a currency which a government cannot print (such as the euro). 

So how do interest rates in Central Europe compare on 10-year bonds? The Czechs are doing very well at below 4% yields, the Poles are at approximately 6%, the Romanians at about 6.5%, and Hungarian yields have recently shot up to nearly 10%. (The above Central European yields are all in local currency).

A number of Central European governments would do well to reduce debt and otherwise restore a higher degree of confidence of financial markets. Take a hypothetical example: if reduction of national debt by 20% would allow a reduction of interest rate of 40%, the country would pay, over time, less than half of the interest it might otherwise need to before debt reduction and increasing confidence. (This is a gross oversimplification, because it neglects the effect of the maturity of loans – e.g. debt of governments is not at variable rates, but matures, and must be either paid off or refinanced).

You might ask, why are interest rates on government debt important for business owners? The answer is because government debt is typically the lowest interest rate applicable in that country – businesses usually borrow at a premium to government rates. There is also the possibility that government debt squeezes out private debt. In other words, the government absorbs so much capital from banks and other lenders, that there is little left for business. So every business owner has a vested interest in ensuring that government keeps their house in order.