Do the bond vigilantes know what they’re on about?

27 January 2012 - John Springford

It is a strange irony that Keynesians have ended up arguing that financial markets are efficient, while free marketeers have ended up arguing the reverse.

Let me explain.

Free marketeers argue that the UK should cut the deficit quickly, so bond markets don’t get spooked, driving up the Exchequer’s cost of borrowing and making government finances unsustainable. They point to the peripheral countries in the euro zone, where Portugal, Ireland, Italy, Greece and Spain are all struggling to convince the markets that they can manage their debts. Britain could easily be in the same boat, they argue.

Free marketeers suggest that sovereign debt market participants are a bit like bank customers during a run. They act in herds. Unless the UK gets out of the danger zone, it could be vulnerable to a panic. Once yields start to rise, everyone starts betting against the state that’s in trouble, and things get out of control. Only fast deficit reduction will keep the cost of borrowing down.

Keynesians respond that there’s not much prospect of blind panic taking hold: euro zone countries are apples and the UK is an orange. Unlike the ‘PIIGS’, the UK has its own central bank, which is buying up government bonds in exchange for printed money. It can carry on doing this, keeping the cost of borrowing down. The UK also has its own currency, which has depreciated by a quarter since the crisis began. This makes Britain’s exports competitive, and helps us grow. And the UK also has a centralised political system, which makes it easy for George Osborne to impose austerity on the public sector. The sovereign debt markets know this, and so have given the UK an easy ride.

So Keynesians argue that the risks for the UK are lower than those facing other highly indebted economies in Europe. They think bond markets are actually highly efficient at pricing risk. Consequently, financial markets price in the lower risk for the UK, and demand a lower yield.

The irony is palpable. Keynesians have long argued that financial markets do not price risk efficiently; that investors act in herds; and that ‘animal spirits’ create cycles of exuberance and despair. Free marketers, by contrast, usually argue that financial markets are so good at using information that the prices for risk rarely get out of whack, and if they do, they quickly correct. This isn’t the sort of world in which irrational panic takes hold.

The debate on fiscal policy has become an incoherent slanging match. The question Keynesians and free marketeers need to answer is: if you were Chancellor, would you steer a middle course between eliminating the deficit overnight and postponing it until we’re back at the trend rate of growth? That is, after all, what Alistair Darling planned to do and what George Osborne is doing. And that’s because they don’t know which way is more fraught with danger. It’s hard to blame them: the economic outlook is highly uncertain, and markets are behaving in strange ways.