Stop the presses! Why can you can never find a vigilante when you need one?
Following our post on the forthcoming Great Inflation, Corin Taylor commented:
"I was at a Policy Exchange event on inflation targeting last night, and Michael Saunders from Citi reckoned that governments wouldn't be tempted to inflate away debt because interest rates on government bonds would then soar, thus imposing crippling debt servicing costs. By contrast, 70s inflation was less expected e.g. sudden oil shock, and so bond yields didn't spike so quickly. He has a point, doesn't he?"
Well, yes he does. If investors can see the inflation coming, and if they dump their bonds, bond prices will fall. Yields will rise correspondingly, and it will cost the government much more to borrow. And if the government knows that will happen, it may decide not to inflate away its existing debt in the first place.
This is the world according to the self-styled bond market vigilantes - big investors who are so powerful they can enforce fiscal and monetary discipline on governments simply by threatening to withdraw funding.
Back in the 90s they became quite fashionable - well, fashionable in fiscal and monetary policy circles at least. Indeed, it's said that the entire premise on which US Treasury Secretary Robert Rubin persuaded Bill Clinton to repair the budget deficit, was that if he didn't, the vigilantes would ride into town and torch the place. (Clinton supposedly once asked Rubin what he would like to be if he could be re-incarnated, and Rubin replied, "the bond market, because it controls everything").
But as you may have spotted, the vigilantes' sales pitch does contain rather a lot of ifs. If they forecast the inflation, and if they sell their bonds, and if the government then responds by disciplining itself, then everything's fine. But if any of those links fails, we simply end up with high inflation and high government borrowing costs - the worst of both worlds.
So we need to ask what kind of a job they've actually done for us over the years.
Let's start by looking at how the cost of UK government borrowing has varied over the last century. The following chart shows the cost in terms of the yield (roughly speaking, the interest rate) on long-term government debt (specifically, a perpetual gilt known as 2.5% Consolidated Stock).As we can see, until the 50s, yields bobbed along in the range 3-4% pa. They did move a bit higher during WW1 and its aftermath, but came right back down during the 30s.
In the 50s, there was a sea-change. Successive governments became addicted to Keynesian demand management, deficit financing, and the printing press, and inflation began to drift up. Naturally, gilt yields followed suit as investors attempted to protect themselves, with our vigilantes presumably well to the fore.
But even though the cost of their borrowing went up, it didn't stop governments borrowing increasing amounts, and it didn't stop them running the printing press.
By common consent, the vigilantes did a particularly terrible job in the 70s.
They failed to stop the lamentable Heath and Wislon governments running hare-brained fiscal and monetary policies. And despite pushing long-maturity gilt yields above 17% in 1974, they fell well behind inflation, which peaked at 25% pa in 1975. In other words, they failed to stop government inflating away its debts. True, they subsequently forced the Callaghan government to crawl on its hands and knees to the IMF, but by then, much of the inflationary damage had been done - the vigilantes had failed to avert disaster before it struck.
So why were they so useless?
Well, according to them, they were blind-sided by the oil price shock - nobody could have foreseen that, so the vigilantes can't be blamed.
Except, in truth, they were already failing before the oil price shock. During the 1970-74 Heath government, they had already allowed gilt yields to fall behind a rapidly rising inflation rate. And they were clearly unable to deter governments from running the presses.
The vigilantes real power emerged later, when they exacted a terrible revenge: for the next two decades they kept bond yields much higher than inflation, pushing up the real cost of government borrowing hugely. So while they failed to prevent the inflationary disaster visited on us by governments in the 60s and 70s, they made quite sure taxpayers in the 80s and 90s paid the price. For taxpayers, the vigilantes piled misery on misery.
Of course, since the 1970s, the vigilantes have grown massively in strength. The globalisation of finance and the abolition of exchange controls means they have much more clout. So how are they protecting us from printing press government today?
The answer is not well.
Here we are with the biggest peacetime fiscal deficit we have ever had, the biggest government borrowing programme we have ever had, and the Bank of England running the printing presses at full throttle. Inflation on the CPI measure has accelerated to 3.2%, and yet that long-term gilt yield in the chart, stands today at just 4.6%. That's not what I call vigilantism.
Why are they so supine?
First, many of them accept the consensus view that deflation and not inflation is the major risk facing us. We strongly disagree (eg see this post).
Second, the Bank of England is buying gilts hand over fist as part of its Quantitative Easing programme, thus bidding up prices and artificially depressing yields. This will reverse when the Easing stops, but by then it will be too late.
Third, many big investors (eg pension funds) are forced by regulation to hold bonds in order to match their liabilities. And right now they are so scared about company bankruptcies they are avoiding corporate bonds, flocking into gilts instead.
So how will it play out?
- sometime next year, inflation will push back above 5%, and the consensus will suddenly decide it's a major problem;
- the vigilantes will saddle up and dump gilts - just at the very moment the Bank of England is trying to sell back the ones it's currently buying;
- meanwhile, our deficit-laden government will be issuing massive amounts of new gilts - somewhere around £200bn pa;
- gilt prices will bomb, and yields will rack up - with inflation at 5% and rising, gilt yields could easily rise by 3, 4, or even 5% from current levels;
- the government's borrowing costs will soar - every extra one percentage point on the yield is an extra £2bn pa on debt interest costs, cumulative;
- by halfway through the next Parliament, debt service costs could easily have increased by £15-20bn pa.
Just like last time, the vigilantes will have arrived too late.
The place will already be in flames.
Unfortunately, they'll still want paying.