Jun 10 2009
The almighty bond market: Niall Ferguson’s concerns about the US deficit explained
Published by Jason Welker at 4:28 pm under
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WikipediaHarvard Economist Niall Ferguson appeared on CNN’s GPS with Fareed Zakaria over the weekend. Ferguson has stood out among mainstream economists lately in his opposition to the US fiscal stimulus package, an $880 billion experiment in expansionary Keynesian policy. While economists like Paul Krugman argue that Obama’s plan is not big enough to fill America’s “recessionary gap”, Ferguson warns that the long-run effects of current and future US budget deficits could lead the US towards economic collapse. This blog post will attempt to explain Ferguson’s views in a way that high school economics students can understand.
Government spending in the US is projected to exceed tax revenues by $1.9 trillion this year, and trillions more over the next four years. An excess of spending beyond tax revenue is known as a budget deficit, and must be paid for by government borrowing. Where does the government get the funds to finance its deficits? The bond market. The core of Ferguson’s concerns about the future stability of the United States economy is the situation in the market for US government bonds. According to Ferguson:
One consequence of this crisis has been an enormous explosion in government borrowing, and the US federal deficit… is going to be equivelant to 1.9 trillion dollars this year alone, which is equivelant to nearly 13% of GDP… this is an excessively large deficit, it can’t all be attributed to stimulus, and there’s a problem. The problem is that the bond market… is staring at an incoming tidal wave of new issuance… so the price of 10-year treasuries, the standard benchmark government bond… has taken quite a tumble in the past year, so long-term interest rates, as a result, have gone up by quite a lot. That poses a problem, since part of the project in the mind of Federal Reserve Chairman Ben Bernanke is to keep interest rates down“
There’s a lot of information in Ferguson’s statements above. To better understand him, some graphs could come in handy. Below is a graphical representation of the US bond market, which is where the US government supplies bonds, which are purchased by the public, commercial banks, and foreigners. Keep in mind, the demanders of US bonds are the lenders to the US government, which is the borrower. The price of a bond represents the amount the government receives from its lenders from the issuance of a new bond certificate. The yield on a bond represents the interest the lender receives from the government. The lower the price of a bond, the higher the yield, the more attractive bonds are to investors. Additionally, the lower the price of bonds, the greater the yield, thus the greater the amount of interest the US government must pay to attract new lenders.
Ferguson says that the price of US bonds has “taken a tumble”. The increase of supply has lowered bond prices, increasing their attractiveness to investors who earn higher interest on the now cheaper bonds. Below we can see the impact of an increase in the quantity demanded for government bonds on the market for private investment.
Financial crowding-out can occur as a result of deficit financed government spending as the nation’s financial resources are diverted out of the private sector and into the public sector. Granted, during a recession the demand for loanable funds from firms for private investment may be so low that there is no crowding out, as explained by Paul Krugman here.
But crowding out is not Ferguson’s only concern. The increase in interest rates caused by the US government’s issuance of new bonds could lead to a decrease in private investment in the US economy, inhibiting the nation’s long-run growth potential. But the bigger concern is one of America’s long-run economic stability. If the Obama administration does not put forth a viable plan for balancing its budget very soon, the demand for US government bonds could fall, which would further excacerbate the crowding-out effect, and eliminate the country’s ability to finance its government activities. In other words, such a loss of faith could plunge the United States into bankruptcy.
Fareed Zakaria asks Ferguson:
“Is it fair to say that this bad news, the fact that we can’t sell our debt as cheaply as we thought, overshadows all the good news that seems to be coming?”
Ferguson’s reply:
The green shoots that are out there (referring to the phrase economists and politicians have been using to describe the signs of recovery in the US economy) seem like tiny little weeds in the garden, and what’s coming in terms of the fiscal crisis in the United States is a far bigger and far worse story.
Finally Fareed asks the question everyone wants to know:”What the hell do we do?”
Ferguson:
One thing that can be done very quickly is for the president to give a speech to the American people and to the world explaining how the administration proposes to achieve stabilization of American public finance… the administration doesn’t have that long a honeymoon period, it has very little time in which it can introduce the American public to some harsh realities, particularly about entitlements and how much they are going to cost. If a signal could be sent really soon to the effect that the administration is serious about fiscal stabilization and isn’t planning on borrowing another $10 trillion between now and the end of the decade, then just conceivably markets could be reassured.
Ferguson is saying that only if the Obama administration begins taking serious steps towards balancing the US government’s budget can it hope to stave off an eventual loss of faith among America’s creditors (and thus a fall in demand for US bonds). It will be a while before tax revenues are high enough to finance the US budget. But if the country does not begin working towards such an end immediately, it may find itself unable to raise the funds to pay for such public goods as infrastructure, education, health care, national defense, medical research, as well as the wages of the millions of government employees. In other words, the US government could be bankrupt, and its downfall could mean the end of American economic power.
The power of the bond market should not be underestimated. America’s very future depends on continued faith in its financial stability and fiscal responsibility.
Discussion Questions:
- Why do you think the US government has such a huge budget deficit this year? ($1.9 trillion) Previously, the largest budget deficit on record was only around $400 billion.
- How does the issuance of new bonds by the US government lead to less money being available to private households and firms?
- Do you think investors will ever totally lose faith in US government bonds? Why or why not?
- In what way is the government’s huge budget deficit a “tax on teenagers”? In other words, how will today’s teenagers end up suffering because of the federal budget deficit?
To learn more about the power of the bond market, watch Niall Ferguson’s documentary, The Ascent of Money. The section on the bond market can be viewed here:
About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". Related posts:
- A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
- “The Ascent of Money” – Economic historian Niall Ferguson on the Colbert Report
- Loanable Funds vs. Money Market: what’s the difference?
- Economics in plain English: Understanding Argentina’s budget woes
- Will the stimulus package “crowd-out” private investment and reduce long-run growth potential in America?
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The US Government has the incredibly large budget deficit this year of $1.9 trillion for a few reasons, but mainly because it’s increase it’s spending significantly. The Government has decided that because C and I have decreased they must increase G to keep AD high and hopefully implement the Multiplier Effect (through the $800 billion fiscal policy). The Government is spending a lot of money and (I believe/I’m guessing) cutting taxes too, by increasing their outgoings (spending) and decreasing their incomes (taxes) the deficit between the two will naturally grow; in this case to $1.9 trillion.
Government bonds are one way that the Central Bank of a country can control the amount of money and Interest Rates that are seen in that country. Government Bonds are basically IOU’s that the Government gives to investors in those bonds. If the US government increases the number of bonds available (making them cheaper and more appealing to citizens) then more people will buy them. When more people buy the Bonds (which cannot be spent in stores etc) then there is less money in circulation, thus less money for households and firms.
I think it’s unlikely at this moment that firms will completely lose all faith in US Government bonds because the US Government is very stable. It is unlikely at this moment in time that the US government will collapse/become bankrupt; making the bonds worthless. However if Ferguson’s fears that Obama’s Government doesn’t balance it’s budget properly leading to a massive drop in value of it’s Government Bond’s then I feel it wouldn’t take much more to nudge investors of US Government bonds into fear of US bonds and direct them to more stable Government Bonds.
The current Government deficit is likely to become a “teenager tax” because of the vast scale of it. By racking up trillions of dollars of debt the US Government will have to pay it back at some point. But until the economy begins to recover and starts showing signs of adequate health the US Government cannot start paying back the amounts they might like to. This could take years, and even then paying off the debts will take even more years, thus meaning that the younger generations of today will be paying back the debts when they are older, wiser, and tax payers.
The reason for the huge increase of the budget deficit is due to a few reason as Simon said. Due to the economic problems the US is facing the government sees fit to increase spending in order to increase AD. Due to a fall in C and I as the Keynesian theory says in order to push AD back out the government must increase spending. This is what the US government has done with the $800 billion dollar fiscal stimulus. The aim of the stimulus package is to result in the multiplier effect which should push AD back out.
I doubt very highly that investors will lose faith in the US government to the extent that the government will have to file for bankruptcy and default on their loans, however there might be a possibility that it comes very close. But I would say that other countries such as china would gain more by helping the US then letting them become bankrupt.
The video above stated that the tools we are using at the moment, are not helping the economy and that new “economic revolution” might bring new theories and solutions to the recession we’re in. It seems that neither Keynesian or the Classical view would be helping us in this current situation therefore their must be a balance possibly between the two.
The US budget deficit is so big this year due to the huge stimulus packages, which have only been put into effect this year. Also, the economy is not as strong as it was last year, which could also effect the huge budget deficit.
Investors could lose faith in the government bonds if the U.S. dollar deflates to a huge extent or the budget deficit becomes so great that the interest rates for the government bonds are enormous. If the government becomes bankrupt, this would definitely make the investors lose faith.
The budget deficit is basically a “tax on teenagers” because the teenagers are the future of the country. They will have to suffer the consequences of the budget deficit in the next decades to come. This could include less job opportunities or in general less opportunities for the next generation of the working class.
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Hey Bjorn, I completely agree with what you say. I like the term “tax on teenagers”. Since the US is choosing to consume more today (even beyond their income) , and invest less for the future, it is the teenagers of today who will be paying the price in the future. What I find remarkable is that this is no new concept. In an effort to let as many people as possible live the “american dream” the loans became easy to come by… but at the cost of future consumption. It is slightly shortsighted of current government officials to keep shifting the problem by constantly taking large loans to finance these self created problems. At a certain point, they must shift back consumption to account for all of the “over” consumption they have done during the years. And if they don’t do this, soon enough, other countries may not be will to lend the US any money anymore.
I agree with what Bjorn says and i think that the US government might just be waiting for inflation to lessen their debts, and then pay them back later. i think the government should, after they have come out of the depression, pay back their debts to clear off a lot before no other countries will lend them money.because if that was to happen then then the US would maybe fall into another depression.