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Saturday, October 5, 2013

Fiscal Ratios And Bond Yields (Again)

More discussion on the blogosphere about fiscal risks. Nick Rowe responds to others' (Paul Krugman, Simon Wren-Lewis) posts about Ken Rogoff's fiscal fears (see Nick Rowe's article for the links to the other posts).  

This part from Rowe's article struck me:

 In the normal equilibrium, the quantity of government bonds demanded depends on normal things like the real interest rate on those bonds and the expected probability of default (whether through unforeseen inflation or through simple non-payment of obligations). So in the normal equilibrium, a higher stock of debt, other things equal, means a higher equilibrium interest rate on that debt. And a higher interest rate implies a higher primary surplus needed to service that debt and prevent the debt/GDP ratio rising. And running a primary surplus is something governments don't like to do, and so the higher the primary surplus the higher the risk of default. And the higher the risk of default, the higher the rate of interest would need to be to persuade people to hold the debt. Which creates a positive feedback loop, because it means a higher primary surplus...which might create a crisis, if the positive feedback effect is strong enough.

[UPDATE: Upon re-reading what I wrote here, I realise that I should have noted that the text above is not necessarily what Nick Rowe believes; he is constructing a possible explanation for the existence of fiscal risks.  And my comments here are deliberately missing a lot of his argument in order to give a short response. Think of this as a quick summary of a longer critique.]

I will repeat what I've written elsewhere: if you build into your model the assumption that investors demand an increasing risk premium as debt ratios rise, there is a risk that debt "spirals out of control" within the model. But that is just an obvious consequence of your assumption; to use a fancier word, it's a tautology. But if you assume that bond markets are efficient (no risk premium based on fiscal ratios, since default does not exist in the context of the model), this effect disappears.

There is no way of deciding which assumption is correct without looking at the data: the different assumptions should generate different predicted behaviour. I will point to two observed effects:
  • Observed (nominal) bond yields drop as debt-to-GDP ratios rise. Yes, this result is somewhat flimsy for a number of reasons, but it does raise the bar for the belief in fiscal risk premia.
  • It is very difficult to explain current JGB yields, or even Treasury yields if the fiscal risk premium is anything more than 20-30 basis points. This is too small to measure, and is too small to generate the feedback loop described above.

(c) Brian Romanchuk 2013

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