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.
