"Rising government bond rates prove policy works
By Martin Wolf
Published: June 2 2009 20:24 | Last updated: June 2 2009 20:24
Is the US (and a number of other high-income countries) on the road to fiscal Armageddon? Are recent jumps in government bond rates proof that investors are worried about fiscal prospects? My answers to these questions are: No and No. This does not mean there is no reason for worry. It is rather that there are powerful arguments against fiscal retrenchment right now and strong reasons for welcoming recent moves in the bond markets.
Last week, the Financial Times carried two columns arguing that the US fiscal path was unsustainable, one by Stanford University’s John Taylor and the other by the Harvard historian Niall Ferguson. The latter, in turn, was a comment on a debate with, among others, the New York Times columnist and Nobel laureate Paul Krugman at the end of April.
On one point all serious analysts agree: public debt cannot rise, relative to gross domestic product, without limit. To embark on fiscal stimulus in the short run, one must be credible in the long run.
So what is the disagreement? Prof Ferguson made three propositions: first, the recent rise in US government bond rates shows that the bond market is “quailing” before the government’s huge issuance; second, huge fiscal deficits are both unnecessary and counterproductive; and, finally, there is reason to fear an inflationary outcome. These are widely held views. Are they right?
The first point is, on the evidence, wrong.The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.
At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October (see chart). Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real.
What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone. Hurrah!
It is true that spreads between conventional US bonds and bonds issued by Germany and the UK have narrowed (see chart). But US yields were extraordinarily depressed during the panic. Normality returns.
If inflation expectations are not worth worrying about, so far, what about the other concern caused by huge bond issuance: crowding out of private borrowers? This would show itself in rising real interest rates. Again, the evidence is overwhelmingly to the contrary.
The most recent yield on Tips is below 2 per cent, while that on UK index-linked securities is close to 1 per cent. Meanwhile, as confidence has grown, spreads between corporate bonds and Treasuries have fallen (see chart). One can also use estimates of expected inflation derived from government bonds to estimate real rates of interest on corporate bonds. These have also fallen sharply (see chart). While riskier bonds are yielding more than they were two years ago, they are yielding far less than in late 2008. This, too, is very good news indeed.
Now turn to the fiscal policy. The argument advanced by opponents is either that fiscal policy is always unnecessary and ineffective or, as Prof Ferguson suggests, redundant, because this is not a “Great Depression”. Monetarists argue fiscal policy is always unnecessary, since monetary expansion does the trick. Economists who believe in “Ricardian equivalence” – after the early-19th-century economist David Ricardo – argue fiscal policy is ineffective, because households will offset any government dis-saving with their own higher savings.
Economists disagree fiercely on these points. My approach is “Keynesian”: in extreme moments, the excess of desired savings over investment soars. Again, monetary policy, while important, becomes less effective when interest rates are zero. It is then wise to wear both monetary belt and fiscal braces.
A deep recession proves there is a huge rise in excess desired savings at full employment, as Prof Krugman argues. At present, therefore, fiscal deficits are not crowding the private sector out. They are crowding it in, instead, by supporting demand, which sustains jobs and profits.
Prof Ferguson argues that fiscal expansion was unnecessary because this is only a mild recession. The question, however, is why it is only a mild recession, since precursors of a depression were surely present.
The answer, in part, is the aggressive monetary policies of central banks and the rescue of the financial system. But is that all? What would have happened if governments had decided to cut spending and raise taxes? One might disagree on how much deliberate fiscal loosening was needed. But one of the most important reasons this is not the Great Depression is that we have learnt a lesson from experience then, and in Japan in the 1990s: do not tighten fiscal policy too soon. Moreover, historically well-run economies are certainly able to support higher levels of public indebtedness very comfortably.
This, then, brings us to the last concern: the fear of inflation. This is essentially the question of how to exit from current extreme policies. People need to believe that the extraordinarily aggressive monetary and fiscal policies of today will be reversed. If they do not believe this, there could well be a big upsurge in inflationary expectations long before the world economy has recovered. If that were to happen, policymakers would be caught in a painful squeeze and the world might indeed end up in 1970s-style stagflation.
The exceptional policies used to deal with extreme circumstances are working. Now, as a result, policymakers are walking a tightrope: on one side are premature withdrawal and a return to deep recession; on the other side are soaring inflationary expectations and stagflation. It is irresponsible to insist either on immediate tightening or on persistently loose policies. Both the US and the UK now risk the latter. But their critics risk making an equal and opposite mistake. The answer is both clear and tricky: choose sharp tightening, but not yet.
Copyright The Financial Times Limited 2009