Friday, July 27, 2012

Jeremy Warner — We'll only know the economy is recovering when bond yields start rising again


You can see why everyone was so worried. The last time Britain was bailed out by the IMF in 1976, the primary structural deficit was "just" 4 per cent and national debt to GDP was by today's standards a very comfortable 53pc. Today's budget deficit is much higher, with overall debt expected to rise to nearly 80pc, according the last Office for Budget Responsibility forecasts. 
Even now, it's hard to fault the analysis, yet it misses a number of vitally important points. Most important of all, it's handy to have your own currency. This more or less eliminates default risk, if only because the government can simply print the money to honour its debts. And that's precisely what it has been doing with QE, depressing bond yields in the process. 
To the extent that there was capital flight, it has been countered by the Bank of England. These tools have not been available to eurozone periphery countries, which have in effect been borrowing in a foreign currency – the euro. For highly indebted nations, this raises the possibility of default from negligible to probable. 
Yet the analysis also reflects a fundamental misunderstanding of the nature of money, which I have to admit to fully grasping only quite recently myself. Interest rates as reflected in government bond prices are only a reflection of the level of economic activity. When the economy is growing strongly, money changes hands with high frequency, so there is a consequent demand for cash. To satisfy this demand for liquidity, money is withdrawn from bonds, which are in essence just cash locked up for a set period of time. The demand for cash reduces the demand for bonds, causing interest rates to rise. 
Conversely, in periods of low economic activity, such as right now, the velocity of money and therefore the demand for cash falls. Money instead gets parked in bonds, causing interest rates to fall. All this is just a complicated way of saying that when households and companies spend and invest less, they save more and money gets parked in bonds instead.
Read it at the Telegraph (UK)
We'll only know the economy is recovering when bond yields start rising again
Jeremy Warner | Assistant Editor
(h/t Andy Blatchford)

Another major commentator catches on.

1 comment:

paul said...

Interesting post on income distribution:

http://mathbabe.org/2012/07/28/4508/