As if they didn’t cause enough damage by espousing theories that failed to account for the inefficiencies and irrationalities of the real world, many economists are advocating aggressive spend-and-borrow policies to revive the financial crisis-hit U.S. economy that reflect an astonishing degree of naïveté and ivory tower hubris.
In a word, the Keynesian Kool-Aid drinkers are saying that debt doesn’t matter.
As I see it, there are plenty of reasons to challenge the apparent indifference of Paul Krugman, Dean Baker, and others to the parabolic rise in public debt, including the fact that the latest crisis, like many of those before it, stemmed from a similar complacency about the risks of unrestrained borrowing.
But as someone whose long experience in financial markets helped him to anticipate the kinds of earth-shattering developments most economists didn’t see coming, I find the popular argument that current low yields on government bonds are a vote of confidence on current policies to be utterly ridiculous.
For one thing, long-term rates are being influenced to an extraordinary degree by the Federal Reserve, which has been supplying copious amounts of liquidity to the financial sector. With banks unwilling to channel those funds into loans for Main Street, this cheap financing is effectively underwriting their massive purchases of Treasury and other securities, distorting prices (and yields).
In addition, the Fed itself has been the biggest buyer of government bills, notes, and bonds during the past seven months as a result of the quantitative easing program it launched in March. In the second quarter of this year, for example, the Fed absorbed nearly half of all net Treasury issuance.
Overall, the Fed’s balance sheet has more than doubled since the financial crisis began, which has undoubtedly kept a lid on yields across the credit spectrum. Meanwhile, the Fed’s zero interest rate policy and the historical term structure of interest rates have likely anchored long-term yields at lower levels than they might otherwise be.
Treasury markets, in particular, have benefitted from safe haven buying in the wake of the crisis. But there are significant differences between the current episode and those that occurred before, including the fact that the latest upheaval has taken place against a backdrop of widespread global imbalances and extraordinary levels of public and private debt. Many assume that what worked before makes sense now, without really thinking things through.
Government bond prices have also been been pressured lower by a structural shift in asset allocation preferences. A step-change jump in financial market volatility, greater economic uncertainty, and growing pressure among insurers and financial institutions to better hedge long-term liabilities have stirred an impulsive burst of buying of long-term bonds that likely won’t be sustained at the same pace for long.
Yet even in the absence of such influences, the view among economists that financial markets reflect the wisdom of crowds, especially in regard to current policies and the economic outlook, is a supposition that is dubious at best in light of what we’ve seen in recent years.
I wonder, for example, what credit markets were signalling in the spring of 2007, when risk spreads were at all-time lows, while risk — as evidenced by extremes in leverage and speculation and a bursting housing bubble — was at an all-time high? And when global equity markets were hitting record highs in October of that year, what exactly were they telling us about the state of the world economy?
In my view, whatever predictive ability markets once had has been steadily eroded by years of monetary recklessness, a cultural shift away from long-term investing towards short-term trading and speculation, and the shrinking share of market participants — read professionals — who actually understand the fundamentals that matter.
So, to those economists who keep insisting that the large and growing obligations our government is committing us to in the name of saving or increasing jobs — a theory that hasn’t quite panned out yet, as it happens — don’t matter because markets are signalling otherwise, I say one thing.