Monday, December 6, 2010

Are the Bond Market Vigilanates Pushing Rates Higher?

Bond yields have trended higher in the last few weeks.

There have been a variety of reasons, some technical (an avalanche of new municipal supply) and some fundamental (e.g. doubts on whether the second round of Fed bond market intervention will work).

However, any number of commentators have used the recent bond market weakness as firm evidence that the so-called bond market "vigilantes" are pressing rates higher in response to profligate government spending policies.

Although Random Glenings attempts to avoid political commentary, I must note that I share the disappointment of many about the lack of progress on solving our huge fiscal debt problems. It now seems likely that the current level of tax rates will remain intact for at least one more year, if not two, meaning that our cumulative fiscal debt burden will only continue to grow.

However, whenever someone tells me that our government is trying to inflate our way out of the deficits ("that's what governments always do, you know") I usually ask them to give me some historic examples.

Problem is, there really aren't any examples of government deliberating creating inflation to reduce their debt burden.

Last summer UBS economist Paul Donovan came out with a piece that looked back 150 years, and found very few examples of government policies that debased their currencies to reduce their debt burden. It's not that governments are so altruistic as to care about their creditors (nobody loves a banker!) but the practical methods of reducing debt are more difficult than it would seem.

Here's an excerpt:

"The problem with the idea of governments inflating their way out of a debt burden is that it does not work. Absent episodes of hyper-inflation, it is a strategy that has never worked. Government debt: GDP burdens tend to be positively correlated with inflation. ...OECD government debt rises as inflation rises. Meaningful reductions in government debt will require a low inflation future."

Donovan goes on to note that higher inflation rates can work against governments, since this only raises the rates of interest on their debt burdens.

Myth Busted: Inflation Cannot Cure Government Debt