French government bond interest rates fell 30 to record lows, less than 50 basis points above German government bond rates.

The market s reaction was to send Spanish government bond rates even higher.

Italian bond rates had already been falling before ECB President Mario Draghi announced the conditional bond buying plans.

When that happens, inflationary expectations will mount, long term government bond yields will rise, mortgage rates and private market rates will increase, and one would end up with stagflation (inflation and recession).

But the immediate effect on long term bond rates has not been encouraging.

But, by early spring, bond rates for Spain and Italy were again approaching unsustainable levels.

Either way, interest rates would have to fall in order for world bond markets to clear.

Finally, earlier this month, they decided to devote 100 billion to help Spain clean up its ailing banks. The market s reaction was to send Spanish government bond rates even higher.

Unchecked, large financial firms will be able to tap bond markets for decades to come at rates just above what the government pays, regardless of the inherent risk of their asset positions.

Bond market vigilantes already have taken aim at Greece, Spain, Portugal, the United Kingdom, Ireland, and Iceland, pushing government bond yields higher.

In fact, the 30 year inflation indexed US government bond yield as of May 4 was only 0.86 , compared with more than 4 in the year 2000. Such rates are similarly low today in many countries.

Clearly, the Fed s objective is to increase bond prices, in the hope that lower long term interest rates will propel corporate investment.

Not proceeding now with bank recapitalization and government bond purchases would similarly lead to disaster.

To allay anxiety about government profligacy, the ECB built conditionality into its bond purchase program.

So what will happen when central banks start raising interest rates? In 1994, rising short term rates caused increases in long term rates and declines in long term bond prices that were at least double what standard models at the time were predicting.

But it is logical to consider that restoring the sustainability of public finances can have strongly positive effects on confidence and bond rates.

That is likely to be a money losing strategy unless an investor is sagacious or lucky enough to sell the bond before interest rates rise. If not, the loss in the price of the bond would more than wipe out the extra interest that he earned, even if rates remain unchanged for five years.

Interest rates on government debt are still low.

Interest rates on government bonds were racing upward.

Third, Germany s long term interest rates would be unaffected, because Germany would neither be guaranteeing the debt conversion scheme nor backing the ECB s bond issues.

Drastic action is needed to prevent European bond markets from drying up. Trichet has said repeatedly that current ECB interventions do not target interest rates.

That is likely to be a money losing strategy unless an investor is sagacious or lucky enough to sell the bond before interest rates rise.

And the international bond market has expressed its approval by cutting interest rates on Italy s ten year bonds to 4.8 , and on Spain s to 5.5 .

The government is now seeking to decontrol domestic interest rates, create a more robust domestic bond market, and finally remove capital controls. However, with China s economy currently threatened by ongoing yuan appreciation, liberalizing the financial system could have perverse short run consequences.

A dollar bill is an IOU from the government, just like a Social Security Trust Fund bond is.

The fundamental benchmark interest rates in modern financial markets are the so called risk free rates on government bonds.

Economists like to subtract the nominal government bond yield from the inflation indexed bond yield of the same maturity to get a market estimate of the inflation rate from now to that maturity date.

In such systems, the government directly controls the benchmark interest rates.

Until recently, the bond markets treated all euro sovereign debts as virtually equal, not raising interest rates on high debt countries until the possibility of default became clear.

But if they try to prick bubbles early on with higher interest rates, they will crash bond markets and kill the recovery, causing much economic and financial damage.

Bond offering

They buttress their argument that the deficit is not an immediate problem by pointing to very low interest rates on long term government debt, with a 2 yield on the ten year Treasury bond and a negative real interest rate on Treasury inflation protected bonds (TIPS).

Proponents of OMT counter that the Treaty forbids only direct government bond purchases indirect purchases in secondary markets are allowed.

The result would be capital flight but to where? Many banks would have a similar problem a collapse in US Treasury prices (the counterpart of higher interest rates, as bond prices and interest rates move in opposite directions) would destroy their balance sheets.

If not, the loss in the price of the bond would more than wipe out the extra interest that he earned, even if rates remain unchanged for five years.

The resulting uncertainty could trigger more volatility, especially in bond markets, potentially impeding economic recovery (for example, by pushing up long term mortgage rates) or augmenting future inflation risk.

And no approaching government debt crisis in the core economies can be seen when tracking government interest rates.

At this point, inflationary expectations will increase, long term government bond yields will rise, and the recovery will be crowded out.

When an elected government is under assault from the bond markets, it is essential for the political class to remain united.

Long term government bond yields are already very low, and a further reduction will not significantly change private agents borrowing costs.

And lowering the rates that government pays has not translated into correspondingly lower interest rates for the many small firms struggling for financing.

But fears of government default in rich countries could threaten the recovery by causing interest rates to rise and exchange rates to fall.

Policymakers initially resorted to government spending and low interest rates to boost demand.

Government debt service has in general become easier, owing to low interest rates.

These bonds may be seen as a hybrid of a single bond and a double bond, each bond in the ring identical to every other.