People still say to me that the UK or the US had to embark on austerity, because otherwise the markets would have taken fright at the ‘simply huge’ budget deficit. How do they know this? Because people ‘close to the market’ keep telling them so.
What can I do to show that this is wrong? The most obvious point is that interest rates on UK or US government debt have been falling since 2008, but the response I sometimes get is that rates have only stayed low because of austerity policies. So how about looking at one very short period, around the UK general election of 2010. The election itself was on 6th May, but Gordon Brown only resigned on 10th May, and the coalition agreement was published on 12th May.
Labour were proposing a more gradual reduction in the deficit than the Conservatives, but the Liberal Democrats (the eventual coalition partners) were during the election closer to Labour. So if there was any default premium implicit in yields on UK government debt, it should have fallen between 5th May and 13th May, either because Labour were defeated, or because the LibDems capitulated on the deficit. Now you may say that the markets were anticipating a Conservative victory, but even if that is true, on 5th May there was some doubt about that, which should have been reflected in the price. The coalition agreement published on 12th May clearly states a commitment to “a significantly accelerated reduction in the structural deficit”, so that doubt should have disappeared by then. If there was a default premium in rates before 6th May, it should have fallen by 13th May.
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| Yield on 10 year UK government debt: source Bank of England |
As you can see, rates were higher on 13th May compared to 5th May. More to the point, there was no noticeable decline in rates because fiscal consolidation was going to be greater. Now of course other things may have happened over these few days to offset any default premium effect, and you can always spin stories about how markets were concerned about a coalition government so maybe the accelerated deficit reduction was not going to happen, etc. But they are stories: in terms of the data, there is no obvious effect.
The more sophisticated defence of austerity, as here from the Permanent Secretary at the UK Treasury in reviewing William Keegan’s new book, is that there exists a ‘tipping point’ somewhere: some level of the deficit at which the markets will take fright. It is then suggested, with reference to the Eurozone crisis, once you reach that point it is very hard to return, because a vicious circle sets in. Interest rates rise, making any new debt more expensive to service, which raises the deficit itself, making default even more likely. As we do not know where that tipping point is, it is best to stay well away from it by taking precautionary action before it is reached. The problem with this argument is that having your own central bank makes a key difference, not just to the chance of a funding crisis, but to its dynamics as well.
Having your own central bank does not rule out the possibility of default. As Corsetti and Dedola explain, the costs of inflation created by monetising the debt may exceed the costs of default. Markets know that, so they may still at some point begin to suspect that default could happen. It therefore follows that the markets could get it wrong: they may begin to suspect default even when there is absolutely no intention within government to let this happen.
Suppose this fate had befallen the UK or US governments in 2010. The markets suddenly panic that the government may default, even though the government has no intention of doing so. Interest rates start rising on government debt. But both governments have a Quantitative Easing programme, which is designed to keep long term interest rates low, so their central banks respond by buying more government debt. The cost of servicing government debt does not rise, because additional money is created, so there is no vicious circle. There is plenty of time for the government to take whatever action it wishes to take to reassure the markets. And unlike the model of Corsetti and Dedola, because there is a recession and a liquidity trap, the extra money created does not immediately lead to inflation. [1]
Having your own central bank, which is already undertaking Quantitative Easing, does not just make a funding crisis a lot less likely, it also crucially changes the dynamics. If a crisis occurs, the government is not trapped in a vicious circle. This in turn means that there is no obvious reason to act in a precautionary way. So why did no one make this point nearer the time? The answer of course is that they did.
[1] If you think that in these circumstances a foreign exchange crisis will get you, you need to explain why Paul Krugman’s analysisis wrong.
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