Return Of The Bond Vigilante

The reticence of small-government politicians could, presumably, also reflect a more sophisticated understanding of fiscal policy - that in demand-

deficient economies where monetary policy cannot get traction, fiscal expansion is needed to prevent a deep contraction. I doubt, somehow, that this epiphany muffled the fiscal hawks. Persistent low yields are a more credible explanation for a shift in the politics of fiscal policy.

Changing perceptions about sovereign default are also at play. The Japanese and euro area experience with QE fundamentally changed how the market perceives default today. Japan and Italy have deeper challenges with debt sustainability than the United States. There are significant differences between Italy and Japan, but essentially their debt is large, their growth is slower, and their populations are aging faster. That is an onerous combination for debt sustainability.

As in the United States, the stated objective of QE in Japan and the euro area is to push inflation higher. But its unintended effect - some might say its "unstated intent," even though central banks deny it vehemently - has been to remove default premiums from the bond market. When a country with a debt ratio of 240 percent of GDP, as in Japan, manages to lock in 10-year bond yields close to zero, it makes it hard for bond markets to price default probability elsewhere. So, as QE becomes an integral part of the central bank toolkit, it fundamentally alters the market’s perception of default - and its capacity to price it. Fiscal profligacy imposes minimal costs on governments.

It is this factor - the inability of the bond market to price risk premiums - rather than changes in the structure of the economy that allowed higher debt with little collateral impairment. The political process simply gobbled up the free lunch. If anything, the structure of advanced economies may warrant lower debt levels today. Aging populations imply larger future spending on health and pensions, along with a lower capacity to grow.

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Disclaimer: Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.

RAMANA RAMASWAMY is a distinguished academic visitor at ...

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Norman Mogil 11 months ago Contributor's comment

Could the bond vigilantes be operating in reverse? Where the low rates,low term premium signify that monetary policy is too tight ( a la Milton Friedman's argument) and growth is too low?