Return of the Bond Vigilante: Will markets coerce fiscal policy again?

Author:Ramana Ramaswamy
Position:Distinguished academic visitor at Queens' College, Cambridge University
58 FINANCE & DEVELOPMENT | December 2018
BOND MARKET VIGILANTES are a vanishing species.
e label refers to bond traders who are averse to
scal proigac y but also captures politicians who a re
wedded to small government. ey wielded signi cant
inuence over global scal policy for two decades
until 2008 but are fea red no more. e bond market
has been unable to assign risk premiums—higher
yields—to countries w ith unsustainable sca l policies
in recent years. e customar y political forces arrayed
in support of small government have also f allen silent.
e recent reticence of the scal hawks in the US
Congress, for insta nce, has perplexed many.
What happened? Has t he economic structure in
advanced economies changed to accommodate a
larger public debt than reckoned previously? Do es
the Republican support for sca l expansion in a
full-employment economy reect political e xigency,
or is it an indicator of deeper changes i n the econ-
omy? Will bond markets ever pressure governments
again? Gett ing a handle on these questions is critica l
for both policy and market s.
It is no great revelation that quantitative ea sing
(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 ination is much higher tha n
their sensitivity to sca l sustainability. And QE did
not drive ination up as quickly or as much over
time as was envisa ged initially. is combination
of direct bond buying under QE, its fa ilure to rev
up ination given the scale of t he bond purchases,
and bond yields’ strong sensitivity to ination
proved a powerful cockta il in keeping bond yields
low for years.
Low bond yields transformed t he politics of debt
and decits radical ly. ere is less crowding out of
noninterest government spending when yields are
low. at decreases pressure on politicians to make
hard choices between compet ing spending objec-
tives. ere is simply less of a reason to antagoni ze
anybody with spending cu rbs when there is more
to go around. It gets close to a free lunch; railing
against free lu nches would be somewhat quixotic.
e silence of the political forces favoring small
government and balanced budgets re ects mainly
this coexistence of high debt and low yields.
e reticence of small-government politicians
could, presumably, also reect a more sophisticated
understanding of scal policy—that in demand-
decient economies where monetary policy ca nnot
get traction, scal expansion is needed to prevent
a deep contraction. I doubt, somehow, that this
epiphany mued the scal hawk s. Persistent low
yields are a more credible explanation for a shif t in
the politics of scal polic y.
Changing perceptions about sovereign defau lt are
also at play. e Japanese and euro area experience
with QE fundamental ly changed how the market
perceives default today. Japan and Italy have deeper
challenges wit h debt sustainability than t he United
States. ere are signica nt dierences between
Return of the Bond Vigilante
Will markets coerce fiscal policy again?
Ramana Ramaswamy

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