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Wednesday, November 23, 2016

Oh No, The Bond Vigilantes Are Back!

I missed it when it came out, but the article "The bond vigilantes are back, and Trump better pay attention" is suitably cringe-worthy. The analysis contained can only be described as silly, and expect to hear a lot more similar nonsense for the rest of the Trump administration. To the extent that bond yields rise would probably a fair indication of the success of fiscal policy to return growth to more reasonable levels.

My American readers will be celebrating Thanksgiving tomorrow (and then recovering from turkey overdoses and Black Friday shopping), and Canadian readers may be getting ready for the Grey Cup. Not sure what the seasonal greeting is for Thanksgiving, but have a good one, and I will be back next week.

For those of you who want a longer evisceration of the analysis contained in the article, I would recommend Professor Bill Mitchell's "Bank of Japan is in charge, not the bond markets." As the title indicates, he discusses the situation in Japan, where the Bank of Japan has moved to set a ceiling for bond yields. He runs through the theoretical reasons why the central bank effectively determines the level of bond yields; the belief that they are determined solely by "market forces" is an illusion.

For my part, I discuss these issues in "Understanding Government Finance." To briefly summarise my position, bond yields can only become disjointed from the expected path of the short-term policy rate if there is a credible fear of default ("rollover risk"). For a currency sovereign nation like Japan or the United States, a government default would almost certainly be the result of a political decision (although sufficiently advanced incompetence, or a major disaster, could also do the job). With the Republicans coming into control of all of the elected branches of Federal Government, the enthusiasm for a debt ceiling-driven default will wane in that party. (Although Democrats might revert to using the debt ceiling as a lever; Barrack Obama famously voted against at least one debt ceiling increase.)

Once we rule out default, bond yields will only rise if the Federal Reserve is expected to raise rates to contain the inflationary pressures created by "above-trend" growth. Since the announced objective of various fiscal measures was to raise growth rates, that would be a sign of success.

Will It Happen?

The initial indications that the Republican fiscal policy will be characterised by tax cuts (which benefits those who pay the most tax -- the rich) and tax credits for infrastructure investment. My guess is that such moves could inflate the fiscal deficit, although everything depends upon what can be negotiated with the various players in Congress.

It remains to be seen whether this will have much an impact on the economy. This is a case where there is a large difference between popular conceptions of fiscal policy, and Functional Finance (link to primer).

The standard way to look at fiscal policy is to look at it through a financial lens: how large is the dollar amount of the deficit? A larger deficit increases the amount of debt, and allegedly increases the financing risk (and hence term premia).

The Functional Finance analysis asks: what is the effect on the economy?

A tax cut to someone who has a no propensity to consume out of income will largely just end up being saved. Essentially, all that happens is that there is an increase in the stock of financial assets:
  • government liabilities go up;
  • private sector financial asset holdings increase.
There would be no effect on other economic variables. To use the standard jargon, the multiplier on the fiscal policy change would be zero. In order for the multiplier to be non-zero, there has to be an effect on consumption or investment patterns. In other words, we cannot infer the economic impact of a policy by fixating on the financial aspects.

I would not expect the Republican fiscal policy changes to have a multiplier of zero. Conspicuous consumption will rise, and massive infrastructure tax credit would presumably cause infrastructure spending to happen that would not have otherwise. That said, the multiplier would be probably quite low, and so the hand-wringing about the deficit will be far out of proportion to its effect on the economy.

(c) Brian Romanchuk 2016

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