Government Bond Markets: Unfeeling Psychopaths or Rational Keynesians?

27 Feb

With the latest round of “Markets can’t handle democracy” after a minor selloff in BTPs (Italian government bonds) followed the election, the idea that “government finance is too important to be left to the markets” is emerging from the swamp of Guardian comments thread, and shambling back into the mainstream. With all but a few Austrian dead-enders acknowledging that austerity has been disastrous for growth, the accusation of market culpability is a serious one.

The case for the prosecution is that government bond markets irrationally panicked at modest debt increases following the 2008 financial crisis, demanding appeasement in the form of “austerity”, ideally targeted at the poor and vulnerable. (One may need to sprinkle the preceding sentence with the word “neoliberal” to get the full flavour). This case was made most recently in a paper by Paul DeGrauwe of VoxEu, and is noticeable for attracting sympathetic comments from normally sensible people.

Professor DeGrauwe argues convincingly that the countries which instigated the largest austerity programmes suffered the worst damage from markets in terms of both quantity and price of fresh borrowing (his Figure 1 below). He goes on to note that none of the austerity measures introduced pacified markets. He draws the slightly eccentric conclusion from this that markets love and demand austerity. Possibly for reasons of space he omits that the two biggest rallies in EU peripheral sovereign debt before the ECB’s Outright Monetary Transactions (OMT) were driven by monetary actions – the injection of ECB liquidity into the market via SMP and later LTRO. But he does note that the prospect of unlimited monetary intervention by the ECB in the form of OMT is what appears to have convinced markets that investing in the periphery is safe.


So there you have it: fiscal measures did nothing to convince markets to buy peripheral debt; monetary measures were repeatedly successful. Yet the conclusion drawn is that “austerity dynamics were forced by fear and panic that erupted in the financial markets and then gripped policymakers”.

What worked: hint – not austerity
What worked: hint - not austerity

What worked: hint – not austerity

Panic is a funny word. Jumping out of a moving bus can look like panic. However, if the driver – let’s call him Jean-Claude – is absolutely adamant that he wants to drive said bus off a cliff (think of M. Trichet’s threats to pull the repo-able status of Greek debt and later refusal to allow the ECB to get involved in a rescue), and the conductor (Wolfgang) is similarly vehement about fiscal assistance – jumping out starts to look quite rational. The ECB (especially) and the core countries spent most of 2010-mid-2012 declaring an absolute refusal to assist the peripheral nations. As a result, Europe’s money supply began to resemble a badly-sloping field, where all the liquidity is drained from one end (the periphery) and swamps the core.

Where'd all the money go?

Where’d all the money go?

The huge underperformance of peripheral growth owes at least as much to monetary as to fiscal factors. Hence, despite the UK’s utterly dire fiscal performance – and misguided austerity, my homeland never suffered remotely the sort of spread explosion that Euroland saw. Similarly, Denmark – even whilst retaining a peg to the Euro – didn’t suffer contagion. The “panic” Professor DeGrauwe refers to looks a lot more like a rational response to a thoroughly dysfunctional system. The end of this panic coincided nicely with the introduction of monetary measure – the OMT – with the potential to provide Italy with the sort of central bank support that the UK has enjoyed.

In this case, blaming the markets actually is therefore blaming the alarm for the fire, and measures to control spread volatility like measures to prevent fire casualties by removing the alarms. Professor Paul Krugman has been vocal about the indisputable absence of “bond vigilantes” from markets spared the various monetary perversions that Euroland is subject to. The fit between spreads and recession looks a whole lot worse once you include countries which aren’t in the Euro. Looking at the following chart (lifted off Wikipedia) UK fundamentals nestle in the middle of a group of countries which were in deep trouble, whereas Japan has so much debt it’s literally off the scale of the chart. But neither has seen any significant rise at all it its credit spreads. I suggest therefore that Eurowonks stop throwing stones in glass houses.

From Wikipedia. Look, I'm busy

From Wikipedia. Look, I’m busy

3 Responses to “Government Bond Markets: Unfeeling Psychopaths or Rational Keynesians?”

  1. Pedro Vozone February 28, 2013 at 1:50 am #

    It seems you have completely misunderstood the conclusions of Mr DeGrauwe and Mr. Ji: That the markets response was absolute panic to a situation that presented no real danger, and that the interpretation of politicians was that the markets demanded austerity.
    The two graphs demonstrate that government debt to GDP ratio is not what was concerning the markets, as these ratios just got bigger with austerity, but the ECB’s actions did the trick instead.
    As for calling the panic justified, it is completely wrong. The story is more of a panicked passenger that wraps himself around the driver yelling “we are going to crash!”. The other passengers then get panicked and jump out of the bus, sowing disaster! This is exactly the self-fulfilling prophesy financial markets (lead by the rating companies) have caused from day 1.
    Mr. Krugman finishes his article by saying that austerity is not the magic pill, and the politicians need to let go of this concept in order to move on.

  2. Pino Villa March 5, 2013 at 2:26 pm #

    Simple pragmatism; investors are not stupid, they are quite good in seeing the trees from the forest,
    They realize that Italy and Greece are in a downward spiral. Italy and Greece both adopted austerity measure (increase taxes and reduce government spending) rather than addressing system weakness.The cure adopted is actually worse that the disease.
    The cure adopted by Monti showed a patient with rosy cheeks but deep down the serious disease remains (nearly terminal)
    In Italy the fiscal lever does not work; the negative elements of the system outweigh the positive elements; therefore instead of addressing critical elements like corruption, tax evasion and in-efficient government; they raised taxes which had a direct impact on economic growth. Italy does not even have a centralized procurement system; therefore major price difference even up to 20 times for something like a syringe. Government pays 3 times what private citizen pays for iPAD. The value of corruption, tax evasion and bad government is between 130 -150 billion per year, and still have not touched costly government structure (including the EU parliament we have 6 levels).
    Then other aspects like education and justice system require restructuring, school system is in 24 place (last in EU) and we do not have 1 university in first 100. Addressing these negative elements rather than increasing taxes is what politicians and economists should strive for.
    When you system weakness like in Italy, Keynesians policies just do not work.


  1. Bill Gross's March Investment Outlook - February 27, 2013

    [...] Morski: – Government bond markets: Unfeeling psychopaths or rational keynesians? – Blaming the markets actually is therefore blaming the alarm for the fire, and measures to [...]

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