58 FINANCE & DEVELOPMENT | December 2018
BOND MARKET VIGILANTES are a vanishing species.
e label refers to bond traders who are averse to
scal proigac y but also captures politicians who a re
wedded to small government. ey wielded signi cant
inuence 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 reect 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 ination is much higher tha n
their sensitivity to sca l sustainability. And QE did
not drive ination 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 ination given the scale of t he bond purchases,
and bond yields’ strong sensitivity to ination
proved a powerful cockta il in keeping bond yields
low for years.
Low bond yields transformed t he politics of debt
and decits 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 reect a more sophisticated
understanding of scal policy—that in demand-
decient economies where monetary policy ca nnot
get traction, scal expansion is needed to prevent
a deep contraction. I doubt, somehow, that this
epiphany mued 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 signica nt dierences between
Return of the Bond Vigilante
Will markets coerce ﬁscal policy again?
PHOTO: ONUR PINAR PHOTOGRAPHY
POINT OF VIEW