If anyone ever asked me about my favorite graph in economics, I would show them the graph above. My professors once said that the graph is aesthetically beautiful (look at the convergence between 1999 and 2008) but what makes it very special is the amount of information contained in just one graph.
Some have tried to explain what exactly caused the convergence. There’s a lot of economic theories being offered, but I find one particular hypothesis convincing. It’s simply carry-trading. Not the typical currency carry-trading, but government bond (10-year maturity) carry-trading. Private investors in 1999 saw the expected accession of Greece to the Eurozone as a form of risk-minimization: they believed that Greek bonds would just be as valuable as Germany’s risk-free bonds. Since Greece’s interest rates were way higher than Germany’s interest rates, they borrowed money from Germany (with low cost since Germany’s interest rates were comparatively lower than those of Greece) and invest in Greek bonds (with higher return since Greece’s interest rates were comparatively higher than those of Germany). The free market then did it job pretty miraculously: the high demand for Greek bonds increased their price and lowered their yields. Take a look at what happened in 2001-2002. At this point, those who carry-traded since 1999 must have earned tons of money. This act of carry-trading persisted until 2008, when Lehman collapsed, credit rating agencies downgraded Greece, and investors started seeing Greek bonds to be riskier than other bonds in the Eurozone.
The consequence? Private investors started panicking (a legitimate panic, not an irrational one), and each country started having its own interest rate trajectory. In 2012, Greek bonds were perceived as extremely unpredictable in its return to debt investments (notice the double-digit government bond yields), while Germany’s bonds maintained its stability. No wonder why Christine Lagarde wasn’t happy.