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Who is eventually irrational?

If the market was fully rational in its current pricing, policy makers could actually see current low levels of bond yields as a vote of confidence in their long-term credibility. It would then be rational for policy makers to exploit the lowest funding costs ever

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Outside of European peripheral markets, treasury yields have started to trade around all-time lows. In Germany, yields are back at last year’s Euro Crisis 1.0 level, while US treasury yields are in Great Depression territory and UK GILT yields at their lowest point for the last 200 years. Systemic scares and growth fears have conspired to reach this impressive result.

For those still convinced that unprecedented easy monetary policy will lead to large upward inflation risks (and higher treasury yields) or that stretched public finances will trigger near term solvency fears (also pushing treasury yields up), recent market behaviour should provide clear evidence that they have been wrong in anticipating market drivers. However, some will probably argue that higher yields will still arrive at some point in the future on the back of inflation and/or solvency worries and that the market is just temporarily irrational in his behaviour.

Most fiscal policy makers certainly seem to think that this is the case as Core Europe, the UK and the US are all preparing for a significant round of fiscal tightening in an effort to improve public finances before the market changes his mind and starts demanding higher risk premiums from sovereign borrowers that are currently able to borrow at record cheap rates.

At least it seems very hard to justify the current behaviour of these fiscal policy makers in any other way. If the market was fully rational in its current pricing, policy makers could actually see current low levels of bond yields as a vote of confidence in their long-term credibility. It would then be rational for policy makers to exploit the lowest funding costs ever to stimulate final demand at a time that their economies are flirting with a recession again. Partly (but certainly not only) because a new recession would only deteriorate the state of public finances; not help to strengthen them.

So the market must be irrational in the eyes of fiscal policy makers who pursue aggressive fiscal austerity over the next two years to prevent them from being hit by much higher funding costs once the market gets its sanity back. But wait, if the market is irrational in its pricing today, than a unique opportunity has to be in place to exploit this mispricing of risk. A rational borrower would realise that the most effective way to profit from this opportunity was to combine temporary higher borrowing at irrationally low costs with credible measures to lower future expected borrowings. The obvious examples of the latter for the Euro, UK and US governments are efforts to diminish funding gaps for liabilities related to future pension and healthcare schemes.

By taking this approach, average borrowing costs over both the short and long term would actually fall, which on its own would already contribute positively to the solvency outlook for the government involved. Moreover, short-term temporary borrowing can be employed for fiscal stimulus of the economy which will probably prevent a renewed recession or make it less severe. The stronger economic backdrop and utilisation of productive resources which will otherwise be left idle will actually help to mitigate the negative impact of additional borrowing on government finances. It will lead to lower unemployment benefit outlays and higher corporate and household income, which will at least dampen the negative impact of stimulus borrowing for the next two years.

This underscores the puzzling response that fiscal policy makers are currently displaying to combat deteriorating public finances and rising recession risks. Either they believe that markets are rational and use their vote of confidence to support the economy or they are convinced that markets are irrational and exploit the cheap funding opportunities this creates to support the economy for at least as long as the market remains irrational. Whatever the outcome of the sanity-check of the market, it seems difficult not to conclude that another round of temporary fiscal stimulus is the best way forward for policy.

The fact that fiscal policy makers in Europe, the UK and the US are coming to a different conclusion is therefore a bit confusing and contributing to the recent increase in recession probabilities in these regions. The confusion stems from the assumption that policy makers are expected to respond rationally to the market environment that they are faced with. Maybe that assumption is actually the irrationality in our own analysis.

Valentijn van Nieuwenhuijzen , September 2011

Article also available in : English EN | français FR

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