Economist Brian Easton says we are tyrannised by our bond market and that is the way it has to be as long as we are in debt to it

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

‘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.

The rule by British politicians Liz Truss and Kwasi Kwarteng was bound to be short. It was a Rogernomics strategy. The minority Bolsheviks seized power to implement a wonky neoliberal economic regime. But there was no agreement in a larger (which also meant more with ability) and more fractious Tory caucus than was evident in NZ Labour’s in the 1980s. The minuscule Tory party aside, there was no enthusiasm for the approach among the public.

So no surprises that they did not last long; the surprise was that they were felled so early, not by politics but by financial markets. While those who work in the financial sector are more neoliberal than the population at large, the damage was done by the bond market itself.

Roughly what happened was that Kwarteng’s financial package signalled there would be a huge fiscal deficit, which had to be funded by selling bonds. To get the bonds purchased they would have to be more attractive, which entails a higher interest. The proposed deficit was much greater than expected, so interest rates lurched up. Pension funds, unexpectedly caught out, had to sell bonds to rebalance their books, which temporarily increased interest rates further, until the Bank of England stepped in.

This was all reasonably predictable. That Chancellor of the Exchequer Kwarteng failed to predict it, despite him having worked in the finance industry, is a reminder that the workers in the industry need not be as well informed as they present themselves. He had not much training in economics, but like Truss he knew the ideology. This was further compounded by arrogantly cutting himself off from experienced expert advice. He sacked the Secretary of the Treasury, decried the Bank of England and did not bother with the Office of Budget Responsibility.

The financial sector was dismayed. Which probably explains the nonorthodox part of the market response. Normally, an interest rate hike should push up the exchange rate. Instead, sterling fell. The standard explanation is that the market was so uncertain about what the Chancellor was doing that they required a ‘moron premium’ on interest rates to compensate for the additional risk. When Kwarteng went, the sterling  (pound) exchange rate largely recovered, although given other disturbances in foreign markets – especially from the US dollar and the Chinese renminbi (yuan) – it is hard to judge if it made a full recovery. It is said the moron premium has been replaced by a ‘boredom premium’. Certainly, the financial markets appear to have a lot more confidence that Rishi Sunak and Jeremy Hunt will behave in a rational way.

Where does this power of a bond market come from? At the heart of a bond, or any debt instrument, the borrower hands over some power to the lender. That is equally true for your house mortgage since your bank almost certainly includes various restrictions on what you may do; you must have house insurance, you may not rent the place out without their permission ... Of course, the bank is in debt too, to its depositors, so it has restrictions on it as well (like liquidity requirements). Similarly the British pension funds had obligations to their pension investors, which is why they took actions which, ultimately, caused havoc in both financial markets and British politics. I am not saying those working in financial markets have no power, but they have less than many credit them with, or they like to credit themselves.

Are New Zealand bond markets as terrifying? The short answer is ‘yes’. Perhaps they are a little less, because ours are not as complicated. Since the public and state borrows, the bond markets have considerable power, although they are acting on behalf of those who fund them, which in our case includes many overseas.

This puts an onus on the Governor of the Reserve Bank and the Minister of Finance to act rationally and transparently. Yes, the Reserve Bank can change the Official Cash Rate (OCR), which underpins domestic interest rates. But it strongly signals what it is doing (and it keeps in mind overseas trends) so nobody is too surprised. The Minister of Finance can change the public debt target, but he or she must do so transparently, with a clear explanation what is being done. That happened when the fiscal deficit was markedly increased as a part of the Covid control package; confidence was enhanced by many other countries taking similar measures.

So yes, we are tyrannised by our bond market. That is the way it has to be as long as we are in debt to it.

Footnotes

1. Printing money is not a way to avoid debt. A note represents the holder’s deposit in the Reserve Bank (i.e. with the New Zealand government), so the note holder is lending to the state. If there is too much cash in the economy, it can be converted into spending, which may be inflationary if the economy is near capacity. The inflation may be in consumer products, but it can also be in other markets as occurred with housing.

2. You may have noticed that the Bank for International Settlements reports the New Zealand dollar is now the world's 14th most traded currency, down from 10th, having been overtaken by the Singapore dollar, Swedish krona, Korean won and Norwegian krone. I am not too worried. The ranking does not tell us much about our standing in the world. It is true that it may cost us a few jobs in the foreign exchange sector; the redundant could be usefully employed elsewhere. Personally, I fear high-turnover speculative markets like foreign exchange markets. There is nothing in economics which says speculation of that intensity is socially beneficial; we are better to keep our heads down.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.