Public sector replaces private as engine of borrowing

By John Plender Published: April 15 2009 03:00 Last updated: April 15 2009 03:00 With so many countries running big current account surpluses during the credit bubble, the resulting excess savings ensured that bond market vigilantes - investors who go on strike in government bond markets - were well and truly anaesthetised. Government budget deficits, however great, could always be financed without difficulty while markets were awash with petro-funds and surplus Asian and continental European savings. Not so today. In both the US and the UK, recent bond market auctions have met with poor receptions. Last week's fiscal stimulus package in Japan caused government bond yields to rise initially. The inevitability of huge increases in bond issuance to address the economic and financial crisis has prompted alarmist talk about dwindling investor demand, collapsing bond prices and a return of inflation. Meantime, Ricardian equivalence, one of the fine old chestnuts of economic theory, has been making a comeback. This is the notion that where governments finance expenditure by borrowing rather than taxing, rational folk will save more to offset the impact of taxation further down the line. In other words, fear of government deficits turns them into squirrels, thereby offsetting the stimulus that the fiscal largesse is supposed to achieve. So what, in the face of these potentially conflicting arguments, is in store for the bond markets? There is no disputing the reality of a huge potential supply of bonds, but the demand side of the equation is more complicated. To start with, Ricardian squirrels can firmly be discounted. David Ricardo, the 19th century economist, doubted his own theory on the sensible ground that people were not so rational and long-termist. The recent experience of rising budget deficits in Japan likewise casts doubt on the theory, since household savings rates there have declined. That said, what is now happening in the Anglophone economies is that over-indebted households are rebuilding their balance sheets. The private sector's desired savings rate is increasing, while debt is being paid down. In effect, the public sector has replaced the household sector as the engine of borrowing. At the same time, the protracted decline in commercial bank holdings of government paper is set to reverse. In the period following the second world war, banks on both sides of the Atlantic held as much as 30 to 40 per cent of their assets in government paper. By 2007, when the credit crunch began, that had fallen to next to nothing, leaving the banks unusually vulnerable to liquidity problems. Revisions to the Basel capital regime in response to the financial crisis will put greater emphasis on liquidity. The percentage is thus set to rise again. On top of that we now have central banks engaging in quantitative easing, whereby they purchase assets - chiefly government debt - in exchange for money. These demand side influences are together very powerful. That is not to say that investors will have no concerns about inflation. When governments are obliged, in the attempt to stave off deflation, to expand budgets and increase public sector debt rapidly, the risk is obvious. The key to addressing concerns about inflation - and also default - is for governments to articulate credible medium-term strategies to exit from fiscal and monetary largesse. In the meantime, a world that is suffering from deficient demand and large output gaps is not the kind of place where inflation poses an immediate threat. Yet the scale of potential debt issuance is such that there is bound to be periodic indigestion in the market, with pressure appearing at different points on the yield spectrum. The likelihood is that we are back to the kind of courtship rituals seen in the UK in the 1970s, with investors becoming increasingly coy in the face of a relentless barrage of IOUs. Government debt managers will have to re-acquire marketing skills, which at that time included offering partly-paid gilts and other devices, to add speculative spice to the surfeit of bonds on offer. Stand by for the focus of financial engineering to shift from private to public sector paper. John Plender is an FT columnist and chairman of Quintain