Deficit-reduction advocates assess proper limits of bond market power

“The trust of the financial markets in the full faith and credit in the United States is an asset of all citizens,” he said. “It provides us with an opportunity to borrow at low interest rates. If we decide that [continued borrowing and spending is necessary] to protect the immediate needs of our citizens, then we are consuming out of the asset of that trust.”

Others worried less about higher interest rates and more about the prospect of a “death spiral,” in which confidence erodes quickly, bondholders rush to sell Treasury bonds, and the sudden rush of capital flight requires the government to default on its existing debt.

Arnold Kling, an adjunct scholar at the libertarian Cato Institute, said that the bond market is actually a bad indicator of the likelihood of mass capital flight. “If the bond market could predict death spirals, they would never happen,” he said. “Nobody gets a warning when there is a debt crisis. I mean, we know, generically, that the U.S. is not on a sustainable path. But when will the market lose confidence? Nobody knows that. It will come without warning.”

Kling said that, in his mind, the only solution was to “get control over the deficits.” Several other people interviewed for this article echoed that viewpoint.

But 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, are there ways to mitigate that danger without running the risk of compromising the interests of the public?

Capital controls

In a recent paper for the International Monetary Fund, the economist Carmen Reinhart, also a senior fellow at the Peterson Institute for International Economics, described a range of policy options that governments have utilized in the past to stem capital flight. Reinhart calls the employment of those policies “financial repression,” a term that includes the use of low interest rates, taxes on financial transactions and savings, capital controls, and increased government regulation of the banking sector.

Reinhart points out that nearly all industrialized countries, including the United States, used some mixture of these policies during periods of high government debt since World War II. Her paper documents how such policies were effective not just in limiting capital flight, but also in actually reducing deficits, because low interest rates were often combined with moderate inflation, creating an effectively negative interest rate, in which governments earned money from issuing bonds.

According to Reinhart, current economic conditions look strikingly similar to the period between 1950 and 1970, when many governments had incurred “debt overhangs” — or situations in which the high cost of a country’s debt is combined with a decline in economic health.

“To deal with the current debt overhang, similar policies to those documented here may re-emerge in the guise of prudential regulation rather than under the politically incorrect label of financial repression” she wrote.

Controls of capital movements come in several different forms, from fixed rates of exchange on foreign currencies, to taxes on currency exchanges or other financial transactions, to caps or outright prohibitions on capital movements, such as those imposed by Iceland in 2008 in response to widespread capital flight following the financial crisis.

Kling and others were strongly opposed to the imposition of capital controls or other mechanisms to reduce capital flight in the U.S. That opposition was voiced on different grounds, the most prominent being feasibility.

Foster questions how the federal government could track financial transactions, which occur with the click of a mouse. Williamson argued, however, that though capital controls come with costs in infrastructure and labor, and though there is often “leakage,” or capital movements that escape the notice of regulators, “that doesn’t mean they are entirely infeasible or entirely useless” (see box on next page).

But Minarik pointed out that if the U.S. were to institute regulations that investors perceived as onerous, they would simply invest their money elsewhere in the future. Others, such as Michael Cheah, senior vice president of the investment bank SunAmerica Asset Management, said that capital controls could come with other costs, as well, stifling growth and innovation by making it harder for companies to gain access to financing.

Proponents of greater control over capital markets and movements have often proposed an international regulatory regime, or coordinated domestic regulations between several countries, to address these concerns. When Remapping Debate asked Minarik whether more coordinated international regulation could be a solution to the problems he brought up, he said that a coordinated regulatory approach by several countries was not politically realistic.

Cary Leahey, a senior economist at Decision Economics, a private investment research firm specializing in financial markets, agreed. “We can’t even drum up support in the United States for a tax on millionaires,” he said. But Leahey added that political frameworks have changed drastically in the past, and could conceivably change again. In the last three decades, he said, “the pendulum has swung to take a managed capitalist system and take the management out,” and it could still swing back to a system in which “the worst excesses of capitalism are controlled.”