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

• Author: Ramana Ramaswamy
• Position: Distinguished academic visitor at Queens' College, Cambridge University
• Pages: 58-59

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

PHOTO: ONUR PINAR PHOTOGRAPHY

POINT OF VIEW