Tuesday, August 17, 2010

The Location Of The Bond Vigilantees

Paul Krugman and other American Keynesians have recently gloated over the fact despite the deteriorating underlying fiscal situation for the U.S. federal government, it gets to borrow cheaper and cheaper.

They are right when they say that the massive Keynesian deficit spending initiated by the Obama administration hasn't significantly raised U.S. bond yields. If you compare the yields the U.S. federal government has to pay compared to the yields paid by governments with a similar or stronger fiscal position, it is clear that the U.S. federal government is treated far too positively compared too other governments.

This is a result of the fact that many investors perceive the U.S. federal government as a "safe haven", a perception which then becomes a self-fulfilling prophecy unrelated to any fair assessment of its situation.

But let's leave the issue of the relatively far too low U.S Treasury yields aside for the moment, and instead focus on the overall impact of the deficit on global money markets and the global economy.

Keynesians claim that because U.S. Treasury yields remain ridiculously despite record deficits, this proves that no "crowding out" effect exists. But this overlooks that when large budget deficits increase overall demand for loanable funds, this effect will not be limited to the country that increases its borrowings, it will instead affect all countries. And indeed, in a situation where there is still a lot of pessimism, it will affect countries that are perceived as "un-safe" (like Greece, Portugal, Spain and Ireland) disproportionately while countries perceived as safe (like Germany and the U.S. government) might not be affected at all.

But by pressuring borrowers in other countries to reduce their demand for credit, it will still be a "crowding out" effect (resulting in a higher U.S. trade deficit), even though U.S. Treasury yields don't increase.