Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 4 December 2014

Government debt, financial markets and dead parrots

Following the Autumn Statement, more commentators are noting the similarity between the macroeconomic choices facing electors next year to the choice they faced in 2010. Jeremy Warner even uses the phrase ‘déjà vu’ which I used in the title to this post in August. However what he neglects to mention is the big difference between 2010 and 2015 that I highlighted in that post, which is the absence today of any financing crisis for government debt. For Warner that is understandable - for him, and I suspect a few others, it was always about reducing the size of the state. However for most people in 2010 austerity was sold because of the fear that we would ‘become like Greece’.

This idea that the financial markets are hanging on every short term movement in the government’s budget deficit persists in much of macromedia. It is a myth. It is like the parrot in Monty Python’s famous sketch: it may have lived gloriously once, but now it is well and truly dead, and has been for some time.

You do not need to understand much about financial markets to see why. The market for UK government debt does not exist in isolation, but is instead connected to markets for a whole range of other financial assets. So a small change in the supply of government debt (because of a change in the budget deficit) will have a negligible impact on the interest rate required to sell that debt. [1] The most important determinate of interest rates on UK debt, which is a long term financial asset, is expectations about current and future short term UK interest rates. That is why UK rates on 10 year government bonds are currently around 2%, but for France just 1%: the ECB is expected to keep short rates lower for longer than the Bank of England.

This arbitrage between financial assets assumes that markets believe they will get their money back. The moment the market thinks this might not happen, they will demand a ‘default premium’: a higher interest rate to compensate them for the chance of default. This default premium is our parrot - it is what seemed to swoop up and down day after day during the Eurozone crisis from 2010 to 2012. But this parrot thrived in the Eurozone during that time for a very particular reason. The climate there has now changed, which means it is not what it once was, but it chances of living outside that region were always pretty small, and are today negligible. If anyone tries to sell you one, it will be dead.

If you are thinking about buying government debt and are concerned about possible default, you need to worry about two things. First, you need to ask whether the government will choose to default. It might do so if the political costs of raising taxes or cutting spending become too large compared to the costs of no longer being able to borrow money following default. Second, you need to worry about forced default, where the government is unable to ‘roll over’ (refinance) its existing debt, because the market will no longer lend to it. The two are related, but are not identical. The second risk admits the possibility of a self-fulfilling crisis: default occurs because the market believes default will happen, even if the government actually has no intention to default and can continue to pay the interest on its debt.

This is where your own central bank is very useful. It eliminates this second type of risk, because it acts like a lender of last resort, buying any debt the government cannot refinance through the markets. This is what the ECB refused to do until its OMT programme in September 2012. Until that point, markets were worried that governments in Ireland, Portugal and Spain would not be able to refinance their debt, and so would be forced to default. With OMT the ECB changed its mind, which brought the crisis to an end. The Eurozone parrot was not completely wiped out, because the ECB still made its support conditional, and because the possibility of voluntary default by some governments still remains, but it is not the bird it once was.

The parrot probably never flew in countries like the UK, US or Japan because these countries had their own central banks. Of course many people claim to have seen it, but it seemed to disappear as quickly as it came. The idea that it could survive in the UK or US today is just silly. In 2010 deficits in the UK and US were large, and debt was rising rapidly. It might just have been conceivable (although with a lot of imagination) that the UK or US governments might have chosen to default. Today deficits are near a sustainable level, which means that debt to GDP ratios are relatively stable. If someone tells you they have seen this parrot today, or that it is just resting and will wake if this or that policy is pursued, please respond as John Cleese did:

“'E's not pinin'! 'E's passed on! This parrot is no more! He has ceased to be! 'E's expired and gone to meet 'is maker! 'E's a stiff! Bereft of life, 'e rests in peace! If you hadn't nailed 'im to the perch 'e'd be pushing up the daisies! 'Is metabolic processes are now 'istory! 'E's off the twig! 'E's kicked the bucket, 'e's shuffled off 'is mortal coil, run down the curtain and joined the bleedin' choir invisible!! THIS IS AN EX-PARROT!!”



[1] There may at the margins be some market segmentation, and it is a margin that central banks have tried to exploit through Quantitative Easing (QE). However this involved buying huge quantities of government debt to influence it, and we are still not entirely sure that they succeeded in doing so. Besides that, a few billions on the deficit this year and next is a drop in the ocean.


25 comments:

  1. The 1976 IMF crisis seems to undergird 2010 as much as the troubles in Greece.

    Skidelsky in his column at Project Syndicate (Oct. 21, 2013 'Misconceiving British Austerity') has said that "‘The reality of the 1976 bailout is even more complicated. In the aftermath of the crisis, Chancellor of the Exchequer Denis Healey revealed that the Public Sector Borrowing Requirement had been grossly overestimated in the 1970’s, and that, had he had the right figures, the UK would never have needed a loan. According to him, the Treasury even failed to recognize that the UK would have a tax surplus.’

    And as Alec Cairncross had it, in 1974 the UK economy was fully employed. North sea oil in 1978 was contributing £2.5 billion more than 1974. As such, the 1976 IMF crisis was a problem of borrowing until international prices moderated and north sea oil came on stream. 1974-5 borrowing was short-term and unstable. Interest rates in UK fell because of inflow of funds and the strength of sterling.




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    1. «North sea oil in 1978 was contributing £2.5 billion more than 1974.»

      To the contrary the problem that Darling and Osborne have had to content is not just a global crisis following the credit bubble, but that Scottish oil production has been collapsing, and the UK have become a net oil importer since 2007 (more or less on the day that Blair resigned...):

      http://mazamascience.com/OilExport/output_en/Exports_BP_2014_oil_bbl_GB_MZM_NONE_auto_M.png

      This means that the UK *overall* has to either replace oil extraction with a new source of net profits, or adjust to a massive cut in living standards.

      Since a new large source of profits for a significant chunk of GDP is not readily available, Darling's or Osborne's problem has been how to manage the large cut in living standards.

      Osborne's solution has been to be ««fiscally conservative but monetarily active» and to massively devalue the currency and boost immigration from poor countries, resulting in the *necessary* cut in living standards being done largely at the expense of the below-average in income and wealth.

      Note: I think that given the swing in oil from net exports to imports a cut in living standards across the UK was indeed *necessary*, but it did not have to be done almost entirely at the expense of average and below average wage earners and the unemployed.

      Note: that the global crisis caused by one of the busts of the debt bubble happened more or less at the same time as the switch of the UK to oil net importer has been very fortunate for Darling and Osborne, because it has allowed them to mask the issue of the cut in living standards with the usual "crisis" talk.

      Note: it has been also unfortunate that the switch to oil net importer has happened right as global oil prices quadrupled, making the hit that much bigger, but it has helped the Treasury: since Scottish oil is still being extracted even if in smaller volumes, the quadrupling of oil price has resulted in a quadrupling of oil royalties per barrel, largely offsetting the decrease in volume, but only for the Treasury; effectively energy taxation in the UK has leapt up, and fortunately for Osborne energy taxes affect mostly average and below average wage earners.

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    2. The totally vital point to remember was that the 1976 crisis was all because the UK had a USD denominated debt:
      http://www.nationalarchives.gov.uk/cabinetpapers/themes/sterling-devalued-imf-loan.htm

      It makes a chalk and cheese difference whether government debt is in the government's own currency with a central bank that will act as a lender of last resort or in a foreign currency. If you want to understand anything about bond markets understand that.

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  2. http://www.itv.com/news/update/2014-12-04/ed-balls-well-cut-the-deficit-but-make-different-choices/

    Balls promising to run a surplus by 2020.

    I don't believe that either.

    Risk of default is not the only downside of a large persistent deficit of course.

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    1. Re:surplus by 2020 - I similarly don't believe that, but what "risk of default"? THIS IS AN EX-PARROT!! In fact, it is a parrot that never even existed for the UK.

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  3. "The most important determinate of interest rates on UK debt, which is a long term financial asset, is expectations about current and future short term UK interest rates. "

    Which are not stable or necessarily rationally determined.

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    1. It would be good if people did a model-free analysis of this that really investigated how it has worked over time. Investors are generally fairly passive with respect to holding government bonds of industrialised countries and generally maintain a fixed proportion of them in their portfolios. A sell-off is very unlikely, and not in fact, when there is a lot of uncertainty in the economy.

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  4. Why bother to even mention a prat like Warner?

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    1. Warner has been sniping at SWL in his columns for a while. I think SWL is just returning the favour.

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  5. Balls is a fool to promise to run a surplus. Deficits are entirely normal, and he could quite easily promise to reduce it but say that there are other priorities (growth, real jobs, etc.). But I guess he does this out of fear of being crucified by macromedia's current obsession with the deficit and debt.

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    1. «fear of being crucified by macromedia's current obsession with the deficit and debt»

      "macromedia" is not insane; it is written from the point of view of a particular constituency, just like most news in the USA are written from the point of view of *investors* (so higher GDP "good", higher GDP per person "not so good").

      Macromedia in the UK is usually written from the point of view of what is of interest to rentiers, and in particular financial rentiers, and rentiers who are also (net) employers, directly or indirectly. So anything that boosts wages and employment or risks a reduced ability to pay financial rents is bad.

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  6. I'm confused. I have become used to you saying that all the mediamacro fuss about the deficit was nonsense, then in this post you say "Today deficits are near a sustainable level" which suggests a view that formerly they were unsustainable and needed to be paid down. Which is it?

    As for mediamacro, Andrew Neill on Newsweek did go with the argument that perhaps the deficit was not as big an issue as it had been blown up to be. First sign of sense creeping into mediamacro?

    I've always thought there was no real problem, and that it was a political angle all along; Sterling was not going to default, that was pure invention. And again on Newsweek, A Neill Esq suggested the UK deficit was now bigger than that of Greece, but that's just "Hyperbole" isn't it?

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    1. Sustainable has a precise meaning which I am using here - could these deficits go on forever. And the answer for 2010 deficits is clearly no. The question is when do you start to address this problem, or indeed worry about it at all. And the answer I have always given is that you only worry about sustainability when interest rates are well above their lower bound. I hope that clears up the confusion.

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    2. Surely it is a question of whether the things that cause a deficit (surplus) are sustainable or not? i.e., in policy terms: fiscal and monetary policy. If they are pro cyclical they will cause the deficit (surplus) to be larger and to occur at a faster pace than otherwise. If they are counter cyclical they will, given a fair wind, counteract the cycle. Osbourne is preaching austerity while running a deficit, alas the deficit is not large enough and we are mired in stagnation.

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    3. "you only worry about sustainability when interest rates are well above their lower bound"

      Doesn't this run the risk of leaving it too late? Interest rates are low for technical reasons that will at some point cease to persist, and they can rise quickly if sentiment turns. This means in practice that government has to anticipate the direction of rates, which is extremely difficult to do (otherwise I'd be rich). Without the benefit of hindsight a decision not to tackle the deficit in 2010 based purely on the level of interest rates would have been reckless.

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  7. It's pretty clear to me (as clear as knowing the inside of Osborne's head can be) that he has no earthly intention of ending up at the surplus he's outlined. These are statements made for the benefit of the markets - as Simon rightly says, the markets aren't going to turn us into Greece in reality, but I'm not convinced Osborne thinks that way.

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  8. I think i prefer the Dead Parrot to Krugman's zombies & cockroaches, just wish this kind of article would get more press on the BBC!

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  9. Dear Simon, thanks for the great post (as usual)... but thanks also for the great laugh, the MP's Parrot sketch is just fantastic!
    Patrick VB (Brussels)

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  10. «If you are thinking about buying government debt and are concerned about possible default, you need to worry about two things.»

    That premise astutely suggests to the reader without actually saying so that the only thing that prospective debt buyers are concerned with is legal default.

    It does not say so because prospective debt buyers know history and have read the same books that SWL has read, which point out that the issue is not default, it is *haircut*/*cramdown*, and "haircut"/"cramdown" means getting a negative return on investment.

    Overt "default" is not the only way of giving bondholders a haircut/cramdown:

    «First, you need to ask whether the government will choose to default. It might do so if the political costs of raising taxes or cutting spending become too large compared to the costs of no longer being able to borrow money following default. Second, you need to worry about forced default, where the government is unable to ‘roll over’ (refinance) its existing debt, because the market will no longer lend to it.»

    Those are the two "official default" ways of giving a haircut/cramdown, but monetizing the debt:

    «This is where your own central bank is very useful. It eliminates this second type of risk, because it acts like a lender of last resort, buying any debt the government cannot refinance through the markets.»

    results in a third way to give a haircut/cramdown to the bondholders, because it shifts the issue from getting an haircut/cramdown on government bonds to getting an haircut/crandown on the currency in which they are denominated.

    Then there is *fourth* common technique of haircut/cramdown for currency issuers, which is related to the third: a massive devaluation of the currency. The UK has already done a 25% devaluation over the past few years, and the Treasury has been pushing hard the sale of very long maturity debt to replace shorter debt, which as Osborne officially stated has the purpose to lock-in long term low rates.

    Which only makes sense if he is planning either massive internal inflation (third type of haircut/cramdown), or massive external devaluation (fourth type of haircut/cramdown), to evaporate a lot of the real value of that long term debt, and it being long term, the cost of the partial default will be borne by the holders.

    Put another way, haircut/cramdown can be done by either repaying only part of the bond face value, or repaying the full face value in some partially devalued currency.

    And the currency can be partially devalued either by general inflation, or by external devaluation.

    The two are related because external devaluations of the currency in which the bonds are payable tend to create internal inflationary pressures.

    But Osborne has already shown how he wants to handle that: pushing down real median salaries, which have gone down 20% in the years in which the currency fell by 25%.

    Put another way the Osborne plan seems to make the costs of crisis adjustments fall onto:

    * some part on foreign bondholders via a massive devaluation, which they won't be able to avoid they will be locked in long term bonds;

    * mostly on domestic median workers via a ferocious fiscal squeeze and more immigration from very poor countries pushing down their real incomes and living standards and up the unemployment of wage earners;

    * most of the benefits to accrue to top property owners, as their assets protect them from internal inflation by becoming cheaper and more marketable in terms of foreign currencies.

    We have seen that happening in the past several years, and it has worked.

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    1. I was careful to say that the main determinate of long rates (interest rates on government debt) was current and expected future short rates. In addition, you need to think about default. Both domestic inflation and depreciation get into the first part, because they influence expected future short rates.

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  11. If you are thinking about buying government debt and are concerned about possible default, you need to worry about two things. First, you need to ask whether the government will choose to default. Second, you need to worry about forced default. Third, you need to worry about implied default via inflation. Three things! If you are thinking about buying government debt and are concerned about possible default, you need to worry about three things!

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    1. I think this is confusing. I said the basic determinate of long rates were expected future short rates. On top of that you need to worry about default. If you adopt that framework, you would not count future inflation as default, because it influences future short rates. If nominal interest rates were already high because inflation was high, you would not say you want a still higher return to compensate for inflation - that would be double counting.

      I think to describe inflation as implicit default is just confusing. Of course, if you had indexed linked debt, you do not need to worry about inflation, but you still need to worry about default.

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    2. Sorry if my comment was confusing: it was mostly just supposed to be a Monty Python gag.

      However the serious point is that an investor in gilt isn't really worried about actual default at all, since as you point out it's something that can never be forced on a country with its own currency and central bank. In a sense inflation is the only thing an investor in gilts is really worried about.

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