Today’s letter is sure to enrage all of my libertarian and conservative pals, but here it goes nonetheless.
My right wing friends love to point to the ballooning government debt and claim it needs to be instantly reigned in. These debt alarmists create flashing, anxiety-producing web sites that highlight the ever growing indebtedness levels.
And yeah, I get it. There is a lot of government waste and too many resources spent on non-productive uses. Yet I would argue there is a tremendous difference between investing in infrastructure like roads or fibre internet for all homeowners, and the more the typically thought of government waste. But that doesn’t matter. I have no desire to get in a philosophical debate. I understand the yearning for debt to be cut - it sure appears scary, and the government seems incapable of beating itself out of a wet paper bag, so getting the government out of the way seems logical.
But here is a thought experiment.
There is no doubt when government spends too much it creates inflation and crowds out private investment by forcing up interest rates. Way back in the mid 1990s, when bond vigilantes would drive up interest rates the moment government spent too much, Bill Clinton cut spending as a way to improve the economy. He came to understand that reigning in spending would ultimately result in a stronger economy:
“You mean to tell me that the success of the program and my re-election hinges on the Federal Reserve and a bunch of fucking bond traders?” - Bill Clinton
Clinton was convinced to listen to the signals the bond market was sending him. And this experience is not unique to the United States. During this period Canada’s finances were a complete shit show. The Canadian government was borrowing heavily from the Japanese. My old man knew one of the senior officials at the ministry of finance and he related stories about the Japanese demanding cuts in spending otherwise they would not continue financing the debt. Time and time again, any government over spending was instantly met with massive bond selling and rising interest rates.
So I ask you, if government over spending caused interest rates to spike, what caused this?
Don’t bother emailing me - I can hear the cries already. That’s not fair! Central Banks are pinning short rates at these low (and some cases negative) levels causing the bond market to be bid.
Well I ask you, if Central Banks were keeping rates too low, what would be the outcome? Inflation. And what is a sovereign bond investor’s worst nightmare? Inflation.
So if short rates are too low, investors should be fleeing long bonds. Ok, it’s not quite that simple, and I won’t bother going through all the different elements that go into pricing long term sovereign bonds, but I don’t buy for one second that Central Banks currently control the long end of the bond market.
Look at the Bank of Japan. Last week they announced they would pin the 10 year part of the curve at zero. That lasted two days before the market pushed rates to negative 10 basis points. They couldn’t even keep 10 year rates at zero past the week-end.
Actually I take that back. Central Banks can control the longer part of the curve, but they have to forfeit control of the money supply. The Bank of Japan doesn’t want to sell 10 year JGBs to keep the curve at zero because that would reduce the money supply, something they don’t want to do right now as they want inflation, not deflation.
I am nitpicking, but let’s step back and ask ourselves, if governments were really spending too much, would global long bonds really be hitting all time low yields? Not lows for this cycle. Not lows for the past decade. Not lows for this century. We are trading at levels never seen in the history of fixed income.
How can debt alarmists claim governments are spending too much? Do they have such little faith in markets to dismiss the signal the bond market is sending? And don’t give me the line that hedge funds and other market participants cannot take on the Central Banks. George Soros became a household name by breaking the Bank of England.
Bonds are screaming the exact opposite message that the bond vigilantes previously threatened. Too much government spending used to cause rates to spike higher. Today, too little government spending is causing yields to plummet to levels that are causing an unprecedented different kind of financial stress.
Meanwhile, Central Bankers, like complete mopes, are applying more and more monetary stimulus to counteract the lack of fiscal spending. In doing so, they are delaying the needed fiscal response. Yesterday Stephen Roach wrote an article in Project Syndicate titled “Desperate Central Bankers” that summed up this point perfectly:
Moreover, frothy asset markets in an era of extreme monetary accommodation take the pressure off fiscal authorities to act. Failing to heed one of the most powerful (yes, Keynesian) lessons of the 1930s – that fiscal policy is the only way out of a liquidity trap – could be the greatest tragedy of all. Central bankers desperately want the public to believe that they know what they are doing. Nothing could be further from the truth.
It is important that government spending be productive. Throwing money at better government employee pensions will not do anything to help our economy. Many right wing pundits use previous boondoggle type spending to give it a bad name. They are correct that too often government spending is wasteful, and indeed makes the debt situation all the worse.
But that shouldn’t stop us from trying to do it properly. The bond market is begging for a fiscal response. Do my right wing pals have so little faith in market signals?
I know I have over simplified many parts of financial markets pricing, but I believe the tide is shifting towards a fiscal response. I hope you will forgive my broad based generalizations. After all, there is such a fine line between stupid and clever.
Thanks for reading,