Tuesday, June 29, 2010

Bond Market to G-20: You're Wrong

As I write this post, the 10-year Treasury note yield has dropped below 3%. The last time yields were this low was in the spring of 2009, in the aftermath of a financial panic and a stock market meltdown. Interest rates have dropped nearly 100 basis points over the last 3 months.

What the bond market is saying, I think, is that the current focus on cutting spending and raising taxes to reduce deficits is wrong. Economic growth remains anemic, unemployment is too high, and without a stimulus from somewhere else we face the real possibility of the economy sliding back into recession.

Again, I do not disagree that deficits longer term are a serious problem. It's just that I think the better solution to raising revenue is through encouraging growth rather than belt-tightening.

Already there are some real-time examples of what could happen if policies are not reversed. This morning's New York Times carried a long article about Ireland:

"When our public finance situation blew wide open, the dominant consideration was ensuring that there was international investor confidence in Ireland so we could continue to borrow,” said Alan Barrett, chief economist at the Economic and Social Research Institute of Ireland. “A lot of the argument was, ‘Let’s get this over with quickly.’ ”

Rather than being rewarded for its actions, though, Ireland is being penalized. Its downturn has certainly been sharper than if the government had spent more to keep people working. Lacking stimulus money, the Irish economy shrank 7.1 percent last year and remains in recession.

Joblessness in this country of 4.5 million is above 13 percent, and the ranks of the long-term unemployed — those out of work for a year or more — have more than doubled, to 5.3 percent.

Now, the Irish are being warned of more pain to come.

I've highlighted one line in the excerpt for a reason. If the US - or any other industrialized country - applies the same medicine that the Irish have to their economy, what do you think the reaction would be if economic growth were to shrink by over 7%? In the US, this would mean nearly $1 trillion of lost economic activity.

And note too that the Irish are not being rewarded for the pain they are experiencing. Irish sovereign debt trades almost 300 basis points higher in yield than German bonds, or about the same level as Greece.

Further in the article:

Politicians here have raised taxes and cut salaries for nurses, professors and other public workers by up to 20 percent. About 30 billion euros ($37 billion) is being poured into zombie banks like Anglo Irish, which was nationalized after lavishing loans on developers.

The budget went from surpluses in 2006 and 2007 to a staggering deficit of 14.3 percent of gross domestic product last year — worse than Greece. It continues to deteriorate. Drained of cash after an American-style housing boom went bust, Ireland has had to borrow billions; its once ultralow debt could rise to 77 percent of G.D.P. this year.

Again, I have added the highlighting, only because it is so austere. In our public sector we are only beginning to ask our public sector employees to do very simple things like contribute to their own retirement plan, or work longer than age 55. Wonder what would happen if we cut salaries by 20%?

There is still time for these policies to change, and perhaps they will. In the meantime, I would suggest keeping an eye on the bond market: in 2007 bond investors say the problems earlier than the stock market, and fled higher risk bonds. If yields continue to decline, perhaps more questions need to be raised concerning asset allocation, at the very least.