Remember the laws of supply and demand? If you do, tell the bond markets.
The CBO reported today that “the current baseline outlook [for the budget deficit] is less favourable than the one presented in September*.”
Excluding spending on the wars in Iran, Iraq and Afghanistan, it projects a deficit of $368bn this year and $295bn in 2006. That compares to $310bn and $202bn forecast in September on the same basis.
And what has the bond market done about this rising red ink? Largely, it’s ignored it. Treasury prices fell today. But the fact is that 10 year yields, at 4.2 per cent, are close to historic lows whilst borrowing is close to historic highs. So much for the bond market vigilantes.
How can we explain this? Here’s my effort.
First, bond markets are globalized and what matters for yields is investors’ willingness to hold the stock of bonds, not just the flow of extra supply.
In this context, this year’s borrowing is chickenfeed. A $400bn deficit is only 4 per cent of MSCI’s estimate of the market capitalization of sovereign debt.
Granted, the red ink looks like lasting for more than a year. But there are huge margins of error in long-term deficit forecasts. Figure 1-3 of the Budget and Economic Outlook suggests there’s a 40 per cent chance of a surplus by 2010. That gives bond bulls something to get hold of.
But why should anyone be bullish of bonds? It’s because government borrowing is, in a sense, the counterpart of pessimism about economic growth – and this pessimism naturally favours bonds.
To see why, imagine a closed economy – which is what the world is. Basic national accounts arithmetic tells us that its GDP is the sum of expenditure components: private consumption (C), investment (I) and government spending (G).
On the income side, GDP is equal to profits (P), wages (W) and taxes (T). So we have:
C + I + G = P + W + T
Rearranging gives us:
G – T = (W – C) + (P – I)
That is, public dis-saving is the counterpart of private saving.
In this sense, big budget deficits around the world are the counterpart of economic pessimism, because it’s pessimism about the future that causes companies to invest little even when profits are high.
I’ve left out of this any account of causality. Adherents of Ricardian equivalence would say private savings are low because government borrowing is high. Keynesians would reverse this statement.
Whatever, we shouldn’t be too surprised that global bond yields are low when global government borrowing is high.
Equally, if capital spending – that is, economic optimism – rises, bond yields could rise even as government borrowing falls. I wouldn’t be surprised to see both happen.
* "Less favourable" is one of the best euphemisms since Emperor Hirohito said in 1945 that “the war situation has developed not necessarily to Japan's advantage.”
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