Recently by Gary North: My Response to New York Times Op Ed Columnist David Brooks: ‘Liberal Democrats’
“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” ~ James Carville
In the American West, an unofficial assembly of private citizens known as vigilantes would gather together to exact vengeance against some suspected evil-doer who had the backing of the local politicians and who could not be prosecuted. If they had a symbol, it was a noose.
There has been a strange fascination with them over the years. They have been ideal candidates for Western movies, from The Ox-Bow Incident to Hang ‘Em High. Called lynch mobs in other contexts, they have often been seen as necessary evils.
I never agreed with the phrase “bond vigilantes.” There is nothing illegal about investors staging a boycott against government bonds because they do not trust either the government or the central bank. The bond investor who says “no” at some price (interest rate) is exercising his legal right as a property owner. He is saying, “I don’t trust the government at this low rate of interest. There should be an inflation premium built into this rate.”
In recent months in Europe, another factor reared its head: the risk premium. For the first time since 1950, investors contemplated the possibility that West European governments might default on their debts. Governments had long promoted the convenient fiction that sovereign debts are always honored by politicians.
So, the phrase “bond vigilantes” probably had its origin in a spin-room of the federal government. Bond investors who demand higher rates are regarded as traitors by politicians. They have broken faith with the full faith and credit of the United States. They say: “A little faith, yes, but not as much as before.”
The bond investor is far closer to a juror than he is to a vigilante. The juror assesses the credibility of testimony by the Treasury. Maybe he votes to release the prisoner. Maybe he votes for a felony manslaughter conviction.
At some point, the jury may even convict for murder conviction. “Guilty as charged, your honor.”
BILL CLINTON MEETS THE BOND MARKET
In late 1992, after his election but before his inauguration, he outlined his economic program to a group of advisors. It was the usual Great Society stuff. Bob Woodward described this meeting in his book, “The Agenda.” In the room was economist Alan Blinder, soon to be part of Clinton’s Council of Economic Advisors, and later to become Vice Chairman of the Board of Governors of the Federal Reserve.
After listening to Clinton’s agenda, Blinder said this. Falling interest rates on Treasury bonds could offset a decline of economic growth due to a reduction in federal spending. (This is standard Keynesian nonsense, as if a reduction of federal spending will not be offset by increases in private spending.) Blinder had doubts that rates would fall. Why? Because, he said, “after ten years of fiscal shenanigans, the bond market will not likely respond.”
Clinton’s reaction has become part of the Clinton legacy, only a few notches below “I did not have sex with that woman, Miss Lewinsky.”
At the president-elect’s end of the table, Clinton’s face turned red with anger and disbelief. “You mean to tell me that the success of the program and my re-election hinges on the Federal Reserve and a bunch of [expletive deleted] bond traders?” he responded in a half whisper.
Nods from his end of the table. Not a dissent.
Clinton, it seemed to Blinder, perceived at this moment how much of his fate was passing into the hands of the unelected Greenspan and the bond market.
Blinder was right. The bond traders decided not to buy bonds at low rates. From October 1993 to November 1994 10-year yields climbed from 5.2% to just over 8.0%. Investors were worried about federal spending. With guidance from Treasury Secretary Robert “Goldman Sachs” Rubin, the Clinton Administration and Congress made an effort to reduce the deficit. Ten-year yields dropped to approximately 4% by November 1998. Clinton ran surpluses in the last three fiscal years – the first time since fiscal year 1969.
Yes, Clinton’s surpluses are mythical. They relied on Social Security payments. You can read about the myth here. But, compared with his predecessors, he ran a tight ship. The bond market forced his hand.
THAT WAS THEN. THIS IS NOW.
A recent Wall Street Journal article brings us up to date about the power of bond traders.
No longer can investors’ bond-selling campaigns pressure officials into politically unpopular tax increases or spending cuts, measures that both Clinton and his predecessor, George H.W. Bush, were forced to adopt to improve the fiscal balance and support bond prices.
What has changed? The Federal Reserve System’s policies. Its decision-makers have decided to accommodate whatever deficits that Congress and the President agree to. “The central bank’s giant purchases in the Treasury market and near-zero interest rates have supported bond prices and marginalized private-activist bond investors.”
Bond yields (rates) are trading at historic lows. But I have argued for two years that these low rates are not the result of FED monetary inflation. Monetary inflation tends to raise long-term rates, because bond investors demand a higher rate of return to compensate them for rising prices, i.e., falling real income.
What is holding rates down is fear. Borrowers fear to borrow; bankers fear to lend. Instead, bankers turn the money over to the FED as excess reserves, for which they are paid essentially nothing. The article admits this, but attributes this to fear in the eurozone. But this decline in rates began three years ago.
That is partly due to the “flight to safety” that Treasurys have enjoyed as investors escape exposure to the euro-zone debt crisis, but it is also because of the Fed’s yield-suppressing actions, which are aimed at encouraging investors to take risks and bolster the economic recovery, and are made possible by a benign inflation environment.
What needs explaining is “the benign inflation environment.” The answer is rising excess reserves, which have offset the increase in the FED’s monetary base.
Chris Ahrens, head of U.S. interest-rate strategy at UBS Securities LLC, in Stamford, Conn., said until risk appetites rekindle and disinflation fears dissipate, the bond vigilante is likely to be “as scarce as the Abominable Snowman.”
So, the FED is trapped. On the one hand, if the U.S. economy remains in the pits, fear will win. Bankers will not lend the money they are legally allowed to lend. The money will not get into the economy. This means that Keynesian pump-priming in the form of $1.3 trillion federal deficits will not work their magic. Stagnation will become permanent, unless there is a recession and things get worse.
On the other hand, if the skies clear, and businessmen start singing “happy days are here again,” bankers will lend. The FED’s monetary base, which went from $900 billion in late 2007 to $3 trillion today will work its black magic. Prices will double or worse. That is hyperinflation. But it has not happened yet.
And although critics have said the Fed has distorted the normal functioning of the Treasury bond markets by crowding out private investors, inflation – the biggest threat to bonds’ fixed value over time and a big worry for fixed-income investors – has remained muted and given the central bank wiggle room.
The Federal Open Market Committee (FOMC), which decides monetary policy, remains in a deflationary mindset. It has ever since July 2011, as this chart reveals.
So, it is clear that the cause of today’s low rates is not monetary inflation. It is fear. Investors think the safest place for their money is in U.S. Treasury debt. There are so many of these investors that the Treasury can borrow money almost for free for 90 days. It can borrow long term for very little.
This puts Bernanke in the catbird seat. Consumer price inflation continues in the 2% per year range. This is low enough so that inflation hawks and bond traders are mute. At the same time, economic growth is in the 2% range. It is high enough so that most Keynesians are not demanding another round of monetary base expansion.
Keynesians want a larger federal deficit, not more fiat money. Keynesian theory identifies the major economic responsibility of government as fiscal policy: taxing and spending. They become advocates of fiat money expansion whenever rising Treasury rates threaten the deficit. That is not the case today.
Bernanke has Ron Paul on his case, but not for long. Paul will retire in January 2013. If he is elected President, this will be a nightmare for Bernanke. It will be a nightmare for the Establishment in general. Council on Foreign Relations Team B would not replace Council on Foreign Relations Team A for the first time since 1928. Unthinkable! So, the Establishment is hoping that Paul will drop out.
So, Bernanke bides his time. He is not being attacked by the mainstream media. He can operate in the shadows, coming out to give his trademarked, footnote-laden speeches that describe what has happened recently, which everyone knows, and list hypothetical FED policies as fallback positions if the current do-nothing policy fails.
This is an ideal period for Bernanke. He can sit on the sidelines. No one except Ron Paul is calling for his scalp, such as it is. He is in Goldilocks country: not too inflationary, not too recessionary, just right. Millions of workers remain unemployed, but this can be blamed on “tight” fiscal policy. That’s not Bernanke’s department. That’s for Congress to resolve.
Bernanke never tires of nagging Congress to get its fiscal house in order. He knows that this is not going to happen. So, he can play the Stern uncle. On February 9, 2011, he lectured the House Budget Committee.
To put the budget on a sustainable trajectory, policy actions – either reductions in spending, increases in revenues, or some combination of the two – will have to be taken to eventually close these primary budget gaps.
By definition, the unsustainable trajectories of deficits and debt that the CBO outlines cannot actually happen, because creditors would never be willing to lend to a government with debt, relative to national income, that is rising without limit. One way or the other, fiscal adjustments sufficient to stabilize the federal budget must occur at some point. The question is whether these adjustments will take place through a careful and deliberative process that weighs priorities and gives people adequate time to adjust to changes in government programs or tax policies, or whether the needed fiscal adjustments will come as a rapid and painful response to a looming or actual fiscal crisis. Acting now to develop a credible program to reduce future deficits would not only enhance economic growth and stability in the long run, but could also yield substantial near-term benefits in terms of lower long-term interest rates and increased consumer and business confidence.
Then he could go back to his office and think: “That ought to hold them for another six months.”
Four months later, when a fight over raising the debt ceiling broke out, he dutifully came down on the side of the ceiling-busters.
Failing to raise the debt limit would require the federal government to delay or renege on payments for obligations already entered into. In particular, even a short suspension of payments on principal or interest on the Treasury’s debt obligations could cause severe disruptions in financial markets and the payments system, induce ratings downgrades of U.S. government debt, create fundamental doubts about the creditworthiness of the United States, and damage the special role of the dollar and Treasury securities in global markets in the longer term. Interest rates would likely rise, slowing the recovery and, perversely, worsening the deficit problem by increasing required interest payments on the debt for what might well be a protracted period.
So, he covers both cheeks of his backside. He plays stern uncle when he lectures Congress on deficits in general, and then plays lenient uncle when push comes to shove over the deficit specifically.
The FED is in wait-and-see mode. As long as Congress lets Bernanke alone, he can sit tight. Like a gambler playing for the house and sitting with a pile of chips, with a chip-making machine in the back room, Bernanke can afford to bide his time. He can play for small stakes, steadily building his pile.
He is like any other bureaucrat. As long as he can evade criticism, he is content. Unlike all other bureaucrats in Washington, his agency gets to set its own budget. The FED keeps whatever money it needs to run its operations. At the beginning of each calendar year, it pays the Treasury whatever it has left over after expenses. This year, it paid $76.9 billion retroactively for 2011.
The name of the bureaucratic game is survival. Bernanke is a survivor. He is not going to rock the boat. He is determined not to get blamed if the boat capsizes. He will take action – inflation – if the necessity arises. Then bond rates will rise. Then the bond traders will reassert themselves. But, for now, he has hanged them high.
January 14, 2012
Copyright © 2012 Gary North