Return of the Bond Vigilante Will markets coerce fiscal policy again?
Bond market vigilantes are a vanishing species. The label refers to bond traders who are averse to fiscal profligacy but also captures politicians who are wedded to small government. They wielded significant influence over global fiscal policy for two decades until 2008 but are feared no more. The bond market has been unable to assign risk premiums—higher yields—to countries with unsustainable fiscal policies in recent years. The customary political forces arrayed in support of small government have also fallen silent. The recent reticence of the fiscal hawks in the US Congress, for instance, has perplexed many.
What happened? Has the economic structure in advanced economies changed to accommodate a larger public debt than reckoned previously? Does the Republican support for fiscal expansion in a full-employment economy reflect political exigency, or is it an indicator of deeper changes in the economy? Will bond markets ever pressure governments again? Getting a handle on these questions is critical for both policy and markets.
It is no great revelation that quantitative easing (QE)—large-scale purchases of government bonds by central banks—fundamentally changed the relationship between debt and bond yields. Having a big new buyer of bonds invariably pushes yields down. What is less obvious is that the sensitivity of bond yields to inflation is much higher than their sensitivity to fiscal sustainability. And QE did not drive inflation up as quickly or as much over time as was envisaged initially. This combination of direct bond buying under QE, its failure to rev up inflation given the scale of the bond purchases, and bond yields’ strong sensitivity to inflation proved a powerful cocktail in keeping bond yields low for years.
Low bond yields transformed the politics of debt and deficits radically. There is less crowding out of noninterest government spending when yields are low. That decreases pressure on politicians to make hard choices between competing spending objectives. There is simply less of a reason to antagonize anybody with spending curbs when there is more to go around. It gets close to a free lunch; railing against free lunches would be somewhat quixotic. The silence of the political forces favoring small government and balanced budgets reflects mainly this coexistence of high debt and low yields.
The reticence of small-government politicians...