Working Papers

Bond Market Vigilantes No Check on Fiscal Excess

I have an op-ed in today’s SMH questioning whether higher inflation and interest rates are the most likely outcome from the fiscal policy excesses that have followed the global financial crisis.  Classical liberals fret about rising inflation and interest rates, but this is not entirely consistent with their view that the expansion of the state is bad for long-run growth prospects, which could be expected to depress both.  This is not necessarily good news for bonds, as it points to an environment of depressed returns across all asset classes.

The latest unsolicited review copy to cross my desk is Accelerating out of the Great Recession: How to Win in a Slow-Growth Economy, by two partners at the Boston Consulting Group.  Like many business books, it is useful mainly for what it tells us about the zeitgeist.  The sub-title says a lot about current expectations for future growth, but I was also struck by this recommendation from the authors:

Prepare for government intervention and changes in the external environment, which will likely include a reduction in consumers’ disposable income and restrictions in free trade.

If this is what sells business books, then we have a problem and it’s not higher interest rates.


posted on 13 April 2010 by skirchner in Economics, Financial Markets

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I’m not sure I understand your last line - is the problem that the authors might be right or that the authors think that such prognostications will sell books. If the latter, why is this a problem?

On your SMH piece, I am a bit confused. While I understand your point that poor long-term growth prospects should mean low inflation, how then did/does stagflation occur? And if stagflation does not occur now, then why aren’t US bonds a good deal, at least for an interim period until US yields fall to Japanese-type levels? In your Jeremy Siegel post of last May, Siegel argued that bonds could not match their previous 40 year returns now. But maybe they could do better than stocks for the next 3-5 years while a Japanese scenario gets priced in?

FWIW, fund manager John Hussman has argued that inflation will remain low for the next few years as deleveraging continues. But eventually, the explosion of government spending will lead to inflation (pointing to a chart of federal spending against CPI inflation). He says:

“To the extent that real goods and services are being appropriated by government in return for an increasing supply of paper receipts, whatever the form, aggressive government spending results in a relative scarcity of goods and services outside of government control, and a relative abundance of government liabilities. The marginal utility of goods and services tends to rise, the marginal utility of government liabilities of all types tends to fall, and you get inflation.”

Any thoughts, Stephen?

Posted by .(JavaScript must be enabled to view this email address)  on  04/13  at  12:14 PM

“is the problem that the authors might be right or that the authors think that such prognostications will sell books. If the latter, why is this a problem”

The problem is the former, but it is not unrelated to the latter.

Stagflation had more to do with the monetary authorities overestimating potential output in the 70s.  They could do it again, but I think it is more likely monetary policy will reflect any reduction in potential this time around. 

This is a scenario in which a returns are depressed generally.  Siegel could still be right that equities will outperform bonds in this environment, but that may not be saying much.  Siegel’s point was that the nominal gains seen from bonds over the last 30 years are not possible given current yields.

Posted by skirchner  on  04/14  at  02:17 PM

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