VAST GOVERNMENT DEBTS ARE RISKIER THAN THEY APPEAR / THE ECONOMIST

Vast government debts are riskier than they appear

A provocative new paper gets central bankers talking at Jackson Hole

At the annual gathering of central bankers in Jackson Hole, Wyoming, attendees enjoy R&R: research and recreation. 

The latter usually involves a pleasant hike by the lake, but last year a rainstorm soaked the assembled economists. 

When they returned on August 23rd a remarkably accurate weather forecast helped them dodge a shower and enjoy some sun. 

This was apt. 

A year ago inflation was still too high and investors were placing bets that interest rates would have to stay “higher for longer”, the economic equivalent of a drenching. 

This year inflation looks all but subdued and central bankers—whose optimistic prognostications have also come to pass—have started cutting interest rates.

And so they took something close to a victory lap. 

Jerome Powell, chair of the Federal Reserve, used his speech to say that America’s labour market was no longer overheated and that the Fed would probably soon join the rate-cutting club. 

“You’re not supposed to say that in public,” joked Andrew Bailey, governor of the Bank of England, when Kristin Forbes of the Massachusetts Institute of Technology suggested that the decline of inflation had been a great success. 

One paper, presented by Carolin Pflueger of the University of Chicago, showed how, contrary to the claims of some commentators, the Fed’s rate rises had been crucial to keeping inflation expectations under control. 

Before inflation took off, even forecasters going against the grain and expecting prices to surge thought the Fed would fail to react to inflation—an expectation that could have caused the problem to become entrenched.

Attendees liked that idea. 

It is, after all, evidence that central bankers helped the sun break through the clouds. 

Yet the paper that stirred the most debate at the get-together told a more circumspect story. 

Hanno Lustig of Stanford University presented evidence that during the covid-19 pandemic American Treasuries, which are supposed to be the world’s safe asset, had become risky. 

The public has been vexed by the 18% rise in consumer prices since 2020 and the interest-rate rises that were later required. 

But at least real wages have risen. Consider, by contrast, the plight of bondholders. 

Between January 2020 and October 2023 the mix of higher inflation and higher rates, which depress bond prices, caused the real value of outstanding Treasuries to fall by 26%.

This, Mr Lustig argued, is indicative of a “risky debt regime”. 

At the onset of the pandemic, the Treasury market was struck by extreme volatility. 

Analysis of this usually emphasises blocked plumbing in financial markets: the dealers who intermediate markets ran out of space on their balance-sheets. 

Mr Lustig, though, presented evidence that investors were in fact reacting to fiscal developments, selling more on days when news broke that the American government would be throwing cash at the crisis. 

Moreover, investors who sold Treasuries did better than those who did not—the opposite of what you might expect if plumbing problems were forcing them to offload securities at fire-sale prices.

Things look better in bond markets today. 

Thirty-year Treasuries yield only an annual 4.1%, with little sign of a risk premium. 

But even if America’s “risky debt regime” was temporary, it might be included alongside the panic that struck British gilt markets when the short-lived government of Liz Truss announced unfunded tax cuts in late 2022, or the sell-off in French markets when investors feared that the hard-right would gain power.

Such events should be disquieting to central banks, for several reasons. 

One is that it casts quantitative easing (QE), the buying of bonds using freshly created money, in a new light. 

It is textbook central banking to stop a panic by buying bonds, so as to unblock the plumbing. 

Buying government debt because investors fear fiscal profligacy is much dicier territory. 

And QE has a fiscal consequence: some of the losses that bondholders might have borne were shifted to central banks, and hence back to the taxpayer. 

Mr Bailey seemed burned by the experience: “I’m not saying we’d never do it, but I think it’s tarnished,” he said of using QE in future, while also complaining that no journalist had written about the fiscal consequences of QE when it was profitable. 

(His copies of The Economist must have been lost in the post.)

A more profound reason that central bankers might worry about a risky debt regime is that—although they do not like to talk about tax and spending—they are only able to control inflation if politicians keep debts under control. 

It is possible that amid a fiscal blowout there is no interest rate which central bankers can set to prevent inflation. 

High interest rates can induce still-bigger deficits as governments borrow more to pay the debt interest bills. 

Brazil is familiar with this problem, and the country’s central-bank governor warned on stage that other rate-setters might be forced to pay greater attention to fiscal policy. 

If America continues on its current trajectory, running a deficit of 7% of GDP even while not in recession, that seems certain.

Rain forecast

This makes today’s optimism in bond markets, as indicated by current pricing, a little curious. 

As Mr Lustig notes, the experience of recent years was not unique. 

Bondholders often take soakings after wars and crises, which usually create a surge in inflation. 

Deflation of a comparable magnitude is rarer—even the slump after the global financial crisis of 2007-09 did not produce it. 

Covid will not be the last virus to cause a pandemic; fraught geopolitics could bring about more wars, or worsen existing ones. 

And governments these days seem more likely to respond with big stimulus to reflate the economy than they were a generation ago.

Central bankers cannot do much about these risks, and deserve a moment of celebration. 

Bondholders who live for the long run, though, should consider the chance that history will repeat itself, and that they will once again be caught in a storm.