Deficit-reduction advocates assess proper limits of bond market power
May 11, 2011 — Despite frequent shorthand in the press that conflates the interests of bond investors and the public (or associates bond investors with the value of “prudence”), it is widely acknowledged — even among economists and experts who advocate for deficit reduction — that the interests of bondholders are not always the same as the interests of the public at large. Indeed, according to J.D. Foster, senior fellow in the economics of fiscal policy at the conservative Heritage Foundation, those interests are inherently distinct.
“There’s never going to be perfect overlap,” he said. “Citizens rely on government for a wide variety of things; bond markets simply are concerned about getting repaid with interest.”
Examining the options
Last week, in the wake of Standard and Poor’s downward revision to its outlook on U.S. government debt, Remapping Debate began to examine the implications of policy makers being focused more on the question, “How well are we reassuring markets” than on the question, “How well are we serving the interests of our citizens.” Did that focus reflect decision-making that, effectively, was not democratic?
This week, Remapping Debate reached out to several economists and other experts who are associated with calls for deficit reduction to get their views on whether and to what extent the bond market needs to be “heeded.”
And we ask, “If the fears of higher interest rates or a debt crisis are rooted in the prospect that capital will flee from U.S. Treasury bonds, and if those fears are constraining the policy decisions available to elected officials? And are there ways to mitigate that danger without running the risk of compromising the interests of the public?”
With that in mind, Foster and others said that, when crafting public policy, officials should always prioritize the interests of citizens over the interests of bondholders and potential investors.
“Presumably, that’s what a democracy is,” Foster said. John Williamson, an economist and senior fellow at the Peterson Institute for International Economics, a centrist think tank, agreed, and added that he was growing increasingly concerned that officials are making policy decisions on the basis of the perceived interests of investors, perhaps at the expense of the public. Though Williamson noted that there are times when the interests of the two groups do overlap, “there is always a choice to be made,” he said.
“One can’t both be dictated to by the bond market and further the interests of the public,” Williamson said. In a democracy, “to have the bond market dictate the position of government is unacceptable.”
Inflation expectations
Nevertheless, others asserted that there is some valuable information that policy-makers can glean from the bond market. Joe Minarik, a senior vice president at the Committee for Economic Development, a conservative think tank that describes itself a “business led public policy organization,” said that, for one, the bond market is an important indicator of inflation expectations. Because bondholders are always concerned that an increase in inflation could devalue their investment, Minarik said, their decisions about whether to invest and what interest rates to demand from the Treasury Department are often a reflection of investors’ expectations for the future inflation rate.
“The bond market is an average of what the world thinks,” he said. “Markets are sometimes wrong because people’s expectations are sometimes wrong, but if the bond market sends interest rates up, [it] is telling you that investors anticipate inflation. You’ve got to decide, ‘Am I so confident that I should ignore the market, or should I pay special attention?’”
Minarik acknowledged that the federal government, particularly the Federal Reserve, spends a great deal of time trying to anticipate inflation in order to determine interest rates and craft monetary policy, and that the expectations of bondholders are not inherently any more valid than the Fed’s expectations. He emphasized that when the expectations of the government and of investors conflict, it does not necessarily mean that the Fed should bring its expectations in line with those of bondholders.
And others pointed out that inflation is actually a perfect illustration of an issue on which there can easily be a divergence between the rate that bondholders and the public think is acceptable.
Anthony Randazzo, director of economic research at the Reason Foundation, a libertarian think tank, said that while bondholders will always like to see a low inflation rate, the Fed also has the power to reduce unemployment by buying large amounts of securities — including Treasury bonds — which can lead to lower long-term interest rates and more robust economic growth, though perhaps at the risk of higher inflation. (The Federal Reserve has recently announced that it is phasing out such a policy, prioritizing a fear of greater inflation over more aggressive steps to help reduce unemployment).
Additionally, many economists make a clear distinction between “hyperinflation” — a double-digit inflation rate — which would be harmful to investors and workers alike, and “moderate inflation” — a rate of about three to four percent — which could, in itself, boost the economy by alleviating household debt burdens. The Fed’s current unofficial inflation target is below two percent.
“You always see this tension between inflation and unemployment in the Fed,” Randazzo said. “It definitely could be that if government officials were more concerned about inflation than they are about unemployment, then what’s done for the benefit of bondholders has the potential to not be as good for Main Street.”
Investor confidence
Minarik and others said that the primary economic indicator that the bond market provides to policy-holders is “investor confidence,” or the likelihood that investors will refuse to buy Treasury bonds, demand a higher interest rate in order to do so, or sell the bonds they already hold.
Minarik said that the confidence of investors is something that policy-makers need to take into account because if federal debt is deemed a riskier investment, investors could demand higher interest rates and it could become more expensive for the government to borrow.