Dangers of Extrapolation...
First Draft of September 8 Principles of Economics Lecture: Financial Markets and Depression Economics

Where Oh Where Are the Bond Market Vigilantes?

Floyd Norris:

Rates Fall as Market Fears Economic Weakness: As 2010 began, there was nearly unanimous agreement in financial circles on at least one thing: Interest rates were sure to rise during the year. That turn of events, which has shocked savers and stunned investors, appears to indicate that financial markets’ worries are turning in a very different direction from those of many governments. The governments are seeking ways to bring down budget deficits, fearing that without austerity they could go so far into debt that they would never be able to borrow again. Investors in the financial markets seem to be much more concerned by the possibility of renewed recession and a general deflation that could send asset values and prices down.... [F]ar from showing a reluctance to finance the American government, investors are seeking safety and evidently believe American government debt is the safest possible investment. They have rushed to send money to the Treasury, thereby reducing borrowing costs for the government.

By late 2009, interest rates had fallen to levels previously thought inconceivable. The annual yield on a two-year Treasury note dipped below 1 percent. But it has since traded barely above one-half percent. Perhaps investors are nervous because they fear governments will swing too far toward austerity. When economies weakened three years ago, talk immediately turned to economic stimulus. This time, much of the discussion in Washington, as well as in many European capitals, has focused on the need to reduce spending and deficits, rather than on the possibility that additional stimulus might be needed to avert a new worldwide downturn....

The growing disenchantment with government spending has led to talk of the world reaching a “Keynesian endpoint,” as Anthony J. Crescenzi, a strategist for Pimco, a large investment firm, put it this summer. At such a time, countries needing to rescue banks and stimulate their economies would be unable or unwilling to do so. The Federal Reserve’s move last week, in which it committed to buying up a small amount of Treasury securities, showed its determination to act but “may have exacerbated the fears,” said Dean Maki, the chief United States economist for Barclays Capital. “The Fed seemed to have significantly downgraded its economic outlook,” but its policy change “appeared fairly minor in comparison.”...

[F]or now, the financial markets seem to fear recession and deflation much more than they fear deficit spending.

Comments