Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 11 December 2014

Bond market fairy tales part 1

In a recent post I argued that the days when budget deficits mattered because of concerns about default are over. In 2010 it briefly looked as if deficits could be so large that default was a real possibility, but we now know that was never true for the US and UK, and within the Eurozone it was only true for Greece, and since then austerity has (unfortunately) brought deficits down substantially. In most countries deficits are now around sustainable levels, by which I mean that they can be financed and sustained at close to current tax rates and spending regimes. 

Which raises the question, why isn’t this common knowledge? Why in mediamacro do people act as if we were still in 2010? In this respect BBC journalist Robert Peston has an interesting post. Robert Peston is no fool, and his coverage of banking issues in particular is rightly famous in the UK. In his post, he notes correctly that there is a huge gap between the amount of austerity planned by Conservative and Labour after 2015. Let me quote what he says next.

“And here, of course, is where we need to ask Mr Market what he thinks of all this….The Tory view is that those [low] interest rates can only be locked in if the government continues in remorseless fashion to shrink the state and net debt. What Labour would point out is that countries in a bit of a fiscal and economic mess and currently refusing to wear the hairshirt that the European Commission thinks necessary, such as Italy and France, are also borrowing remarkably cheaply."

So what Mr. Market should tell Robert Peston at this point is that France can borrow more cheaply than the UK not because the French government is more credible and less likely to default - these are no longer important issues. The reason is that expected future short rates in France are lower as a result of the Eurozone recession. This means that because the Conservatives will cut back on spending more (than Labour), this will tend to reduce demand and output more, which in turn will mean expected future short rates will be a little lower under the Conservatives than Labour (as monetary policy tries to undo the impact of greater austerity). What Mr. Market actually told Robert Peston is as follows:

"And here is where Mr Market may be capricious, according to my pals in the bond market. They say the UK's creditors would probably be forgiving and tolerant of George Osborne borrowing more than he currently says he wishes to do, in that his record of reducing Whitehall spending by £35bn since taking office in 2010 has earned him his austerity proficiency badge. But Ed Balls has never been chancellor, although he was the power behind Gordon Brown when he ran the Treasury and much of the country, both in the lean years from 1997 to 2000 and the big spending Labour years thereafter.
So Mr Balls has yet to prove, investors say, that he can shrink as well as grow the apparatus of the state.”

What Robert Peston's pals in the bond market seem to be telling him (assuming that nothing was lost in translation) is that it is all about Labour's lack of credibility at being able to shrink the state. My immediate reaction: ?!?!? I have two problems.

1) Why the talk about credibility? Talking about credibility makes sense if we are worrying about default, but there is no chance Ed Balls is going to choose to default. You might worry that Labour will not cut the deficit by as much as they plan, which will intensify the mechanism working through monetary policy that I outlined earlier. If that is what his pals meant, why didn't they say this, and why does that involve the markets being capricious?

2) What is this about shrinking the apparatus of the state? Shrinking the deficit yes. But in what world does the return on bonds depend on the size of the state?

So it seems that my understanding of how the bond markets work is worlds apart from the understanding of Robert Peston's pals. I suspect that for mediamacro there really is no choice here: why would you believe an academic economist in their little old ivory tower rather than the guys who are directly in touch with the markets you are trying to understand. The fact the explanation they give you could have been drafted by someone in No.11 Downing Street (the UK Chancellor's residence) just suggests that George Osborne is in tune with financial realities.

Part 2 of this post will be why this logic is wrong.


  1. I heard a BBC journalist this morning make a joke on Radio 5 to Ed Balls that Gordon Brown created the debt crisis of 2008, and the BBC presenter's defence on being asked why he would say such a silly thing was 'that's what the Tories would say'.

    I know that Krugman is going for the 'Rudi Dornbusch’s “overshooting” model of exchange rates, which had an enormous impact on international macroeconomics, and arguably saved it from much of the nonsense that afflicted domestic macro' (Krugman blog, 'Shinzo and the Invisibles' December 7, 2014).

    To return to Gordon Brown, he gave a speech in 2000 to the Royal Economic Society which, while dismissing Friedmanite monetarism, accepted Nigel Lawson's political-economic nostrum that micro and macro had been reversed, so that macro was just about inflation control and micro for unemployment and long-run productivity growth.

    This is probably where the Labour Party and the BBC intersect in their current intellectual difficulties and the trouble both of them have in being taken seriously.

  2. "This means that because the Conservatives will cut back on spending more (than Labour), this will tend to reduce demand and output more, which in turn will mean expected future short rates will be a little lower under the Conservatives than Labour (as monetary policy tries to undo the impact of greater austerity)."

    I'm not sure I follow this. The fact that short term rates are non-zero implies this is not a ZLB situation. Is that correct ?

    If so, then the reason that interest rates might be lower with a smaller deficit is not really because demand and output has been reduced more , but because there will be less competition for available savings and monetary policy will just be doing it proper job of stabilizing AD, not "undo[ing]the impact of greater austerity" (which seems a loaded way of describing it)

    Even within a economic framework where the ZLB hampers monetary policy, then once we break out from ZLB the size of the deficit matters mainly for the way it affects people's perceptions of the likelihood of future inflation and/or default. If Labor is planning a larger deficit this will have an effect (albeit small) at the margin on these expectations and this will have an measurable effect on interest rates.

    1. To clarify, I am assuming that rates would not be at the ZLB under both Labour and Conservatives until 2020 - I hope I'm right! You are right that demand and output need not actually be lower because monetary policy will be easier - that was what the 'tend to' language was meant to convey in a sequential sentence. Perhaps 'put downward pressure' might have been clearer.

  3. How would a sovereign floating fiat currency economy default in its own currency? There is no bill it can't pay in its own currency. The natural rate of interest in such an economy is zero, there are more in "Reserves" accounts at the BoE than there are interbank borrowers. QE has generated far more reserves in addition, than the system needs or appears to want. The BoE is paying interest on reserves to keep the rate at 0.5% it would collapse to zero if it didn't.

    The "markets" are irrelevant. The BoE can bury any trader who attempts to force prices or yields in, so called, "debt" instruments (Gilts or Treasuries), denominated in Pounds Sterling. It just has to threaten to buy unlimited quantities of a Gilt if it goes above 2% say. The "market" will stick at 1.99%. The markets, can only attack countries that use some other countries currency. Like every country in the Eurozone, they all use a foreign currency, the Euro. Greece can't issue Euro, that is, spend new Euro into existence, it has to earn them or borrow them or get a hand out from the only source of Euro, the ECB. That makes them vulnerable to market attack.

    On top of all this, we have politicians of all colours, racing to reduce the deficit to zero. Please could they tell me who is going to pay for the imports. Assuming that the private sector (households and firms), over the next five years, will want to save a bit and / or pay down its debts a bit. In that case, we will have to be running a net export surplus, slightly less than Germany. I don't see that happening, but I do see a lot of maxed out credit cards.

    1. "How would a sovereign floating fiat currency economy default in its own currency?"

      It might choose to default as an alternative to inflating away the level of real debt, raising taxes to pay the interest, or (heaven forbid) actually reducing the deficit size.

    2. So what exactly will happen, if the deficit is not reduced, in an economy that has spare capacity and little inflation?

    3. Exactly. The deficit is only aproblem if inflation picks up, and that is easy to deal with.

    4. As we learned in 1992, the markets are far more powerful than a mere Central Bank. If the BoE engaged in such lunacy, perhaps Gilts could be manipulated thus but Sterling would go into freefall

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    6. Anonymous,

      I agree that a country that issues its own currency can pay any rate of interest on its debt that it likes. MMTers have been making that point for some time. (Milton Friedman and Warren Mosler advocate/d a zero rate).

      That makes a mockery of Cameron and Milliband’s claim that the purpose of deficit reduction is to keep interest rates down. I.e. why court austerity in order to keep rates down if the latter can be achieved WITHOUT austerity?

      Put another way, the procedure should be, first, cut rates to whatever is thought to be the optimum. Second, counter any excess inflationary effect of that by cutting the deficit. But it’s difficult to predict EXACTLY how much of a cut in the deficit will be needed. I.e. I agree with Robert Skidelsky who argued that making deficit reduction itself an important target is a nonsense:

      Stephen H,

      In 1992, the UK government was living in la-la land and the markets had a grip on reality, which is why markets ultimately won.

      If government buys back government debt in sufficient amounts to reduce interest on the debt to Anonymous’s 2% or any other rate, and at the same time makes a firm commitment to countering any excessive inflationary effect with deficit reductions, and assuming markets believe that commitment, then Sterling shouldn’t go into freefall.

    7. Why does the government insist on issuing, so called, "debt" anyway? It doesn't have to, it chooses to do so. Why would the Treasury spend (issue) new money (financial asset), at no cost to itself, into the private sector, and then borrow it back from the private sector and pay interest on it?

      When the government pays your pension into your current account, it also pays the same amount into your banks "Reserve Account" at the BoE. (If it didn't, your banks balance sheet wouldn't balance.) You use your pension to pay the gas company at another bank. The BoE moves the "Reserve" from your bank to the gas company bank. All balance sheets balance again.

      The gas company could use your deposit to buy a Gilt and get some free money with it (interest). The reserve moves to the Gilts account at the BoE to maintain balance. Why is the government giving free money to the gas company and the pension funds and insurance funds?

      (OK, I know Gilts are used by the BoE to absorb "liquidity" (reserves) and push up the LIBOR rate, as its policy interest rate setting tool.

    8. Anonymous,

      You’re right to ask why governments incur debt. Very few people ask fundamental questions like that. Milton Friedman and Warren Mosler who I mentioned above said effectively that the state should not borrow.

      It can be argued that the state is an investor in capital projects like roads should borrow for the same reasons as a private contractor who builds and operates roads would borrow (including “borrowing” from shareholders). But even that idea has been challenged.

      As to the state as currency issuer, I see no reason for borrowing. And as to the state as funder of current rather than capital spending I see no reason for borrowing.

      And finally, I like David Hume’s explanation as to why governments borrow: it enables politicians to ingratiate themselves with voters.

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    11. > comment above about the market, - not that simple from the evidence of QE to move the yield by 0.25% the BoE would have to buy 75 Billion , the whole deficit, and increase its gilt holding by a quarter, and possibly be stuck with them. But more importantly the monetary policy of the BoE is separate from Government fiscal policy, the BoE does not intervene in the market to fund the Treasury borrowings and so the stance that the government is constrained by the markets is not a mockery.

    12. Dinero: You make a good point about QE, but its implications are not what you suggest. The fact that the BoE has to buy so many gilts to influence the rate by so little illustrates how 'deep' the market is, or how powerful arbitrage is. That makes the size of the deficit in any year largely irrelevant to interest rates, which is my point. So the markets are no constraint on the size of the deficit if there is no chance of default.

    13. The BoE would just lower the interest rate it pays on reserves, to lower the base rate and vice versa. The Treasury wouldn't have to sell Gilts unless it wanted to increase fiscal stimulus. Treasury spending would remain as reserves. The ultimate QE move, would have the BoE converting all Gilts back to the money the Treasury spent originally using its keyboard. Remember, the government gets all its spending back as taxes, eventually. It is the private sector saving it that causes the governments deficit. If you don't spend it, the government can't tax it.

    14. On October 15th, after the release of weak US Retail Sales data the yield on the Long Gilt dropped by more than 0.25% in less than an hour and a half

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    16. > Mainly Macro

      a permanent deficit borrowed from the market that is greater than the total annual coupon payments payed to the market IS a default as far as the cash flow to market as a whole is concerned. More is being borrowed than is being paid and if that is permanent the market isn't getting the capital sum returned either. Hence the buyers consideration of what the future market sentiment will allow them to sell at in the future affecting the price at which they a willing to pay now, rather than changes in supply.

    17. Stephen H. The yield dropped on the Gilt because its "market" price went up. Weak retail sales means slowing economy, poorer corporate profits, reduced dividend pay-outs to shareholders. The market looks for safe harbours, the best of which are risk free government bonds. This pushes up prices and "convexity" brings the yield down in a somewhat non-linear fashion.

    18. The rise in Gilt prices was indeed rather apparent to me , as I was trading Gilt futures at the time. In fact this extraordinary move was actually a short squeeze of historic proportions. Volume of 150,000 contracts (£15 billion underlying) pushed yields down over 0.25% at one stage.

  4. if you have political gridlock; that can lead to a default.

  5. Paul Krugman has been saying the opinions expressed in this Blog for the past 5 years.

  6. My view is that because it is true (as anon points out ) that governments don't need to borrow, the interest rate on that debt trends to zero (or whatever the interest rate on cash is) over time, regardless of its duration.

    The other key issue when thinking about government debt is to realise that there cannot really be any difference between the various maturities of it, such that a 1 yr gilt should earn the same return as a 25 yr gilt. So this implies a flat yield curve, which is what the trend has been.

    Because government debt is such a nonsense construct one would expect over time to see the yield curve become anchored at zero as well as being flat.

  7. A small point, but isn't Mr Peston misunderstanding what (or who) Mr Market is, and how he communicates?

    What Mr Peston's mates say is not what Mr Market says. Mr Market is currently saying that he is prepared to lend to HM Government at a rate of 2.6% nominal, repayable in 2068. In return for index linking, Mr Market is currently prepared to lend at a real rate of -0.72% until 2068. Mr Market is not explaining why, or how he is factoring in the possibility of a Labour government between now and 2068. But even the famously capricious Mr Market must think there's a remote possibility.

  8. This is exactly where the rubber meets the road--where the neo-liberal virus spread by elites in the City and the corporate media, in London, New York, Paris and Washington--infecting everyone from bond traders (happily) to BBC reporters (cluelessly)--relentlessly undermines a century of Euro-Atlantic social democratic institution-building.


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