Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.Sure enough, and with dreary predictability, commentators from left and right have divided along partisan lines in their analysis of the deficits. Here’s conservative historian Niall Ferguson:
There is no end in sight to the borrowing binge. Unless entitlements are cut or taxes are raised, there will never be another balanced budget. By 2039, when I shuffle off this mortal coil, the federal debt held by the public will have reached 91 percent of GDP, according to the CBO’s extended baseline projections.
Of course, our friends in Beijing could ride to the rescue by increasing their already vast holdings of U.S. government debt ... [But] the Chinese keep grumbling that they have far too many Treasuries already.
And here’s progressive economist Paul Krugman:
Right now, however, the bond market seems notably unworried by deficits. Long-term interest rates are low; inflation expectations are contained (too well contained, actually, since higher expected inflation would be helpful) ... This is truly amazing. It’s one thing to be intimidated by bond market vigilantes. It’s another to be intimidated by the fear that bond market vigilantes might show up one of these days, even though you’re currently able to sell long-term bonds at an interest rate of less than 3.5%.
Both Ferguson and Krugman seem to think that the danger is that of a “buyers’ strike” in the bond market. Both Ferguson and Krugman are wrong.
The way a buyers’ strike works is this: bond investors fear that huge deficits could lead to inflation down the road as the government tries to print its way out of debt. Hence they demand higher interest rates (lower bond prices) today to compensate for this risk.
Ferguson fears that a buyers’ strike could easily happen in the near future, and hence deficits are something to worry about. Krugman inverts this line of reasoning: he argues that low interest rates are prima facie evidence that a buyers’ strike is unlikely, and so deficits are nothing to worry about1.
They both miss the point. The notion of a buyers’ strike caused by fears of deficit-driven inflation is conceptually flawed, for the simple reason that the government cannot inflate away its debt.
It’s all a question of loan duration. Sure, if the entire government debt were in the form of a single loan of very long duration, with no payments before the maturity date of the loan, then yes, the government could foster inflation / debase the currency over the lifetime of the loan, and thus gyp the lenders.
But in actual fact, the majority of the US government’s debt is in the form of short duration loans – bonds with 2 years or less to maturity. This debt has to be rolled over. If lenders suspect that the government is planning to inflate the currency, then at the time of rollover they will demand higher nominal interest rates on the rolled debt, to compensate for this expected inflation. They will also demand higher real interest rates, to compensate for the additional uncertainty. And so the cost of servicing the debt will actually increase, by an amount greater than the amount of inflation. It’s like running on a treadmill: the government cannot get ahead2.
The facts bear this out. Here’s a chart from UBS showing that changes in government debt / GDP are broadly uncorrelated with the level of inflation.
(Source: UBS, via FT Alphaville; more here)
Note the strong element of feedback (a favorite topic on this blog) at work here. The possibility of a buyers’ strike in the future implies that inflation cannot work as a strategy for debt-reduction; the futility of an inflationary strategy suggests that a buyers strike will not occur in the present. A buyers’ strike is thus a self-negating prophecy; the present (no-strike) equilibrium is maintained; and market yields have nothing to do with the probability of such a strike occurring.
But wait. Does this mean that deficits don’t matter? Not quite. I’ll return to this question in my next post.
# 1Their respective stances would be more credible if it weren’t for the fact that six years ago, Krugman and Ferguson were on the opposite sides of the deficit debate. Back then, Krugman was a vocal deficit hawk, raising the prospect that tax cuts, entitlement commitments and military spending could ‘drive interest rates sky-high’. Meanwhile, Ferguson claimed that deficits were necessary and desirable if that was what it took to maintain the level of military spending required for purposes of US hegemony.
Of course both sides claim to have switched allegiance for the best of reasons. But the cynic in me will perhaps be forgiven for concluding that whether one is a deficit hawk or not depends greatly on what type of spending the deficit is being used to finance.
# 2As a general principle, the only way a government can inflate its way out of debt is to print money so fast that the real value of the debt falls significantly before the debt comes due. For a short-duration debt portfolio (like that of the US), this means hyperinflation.