Deficit addicts revive bond market

By Michael Coote

Friday 31st January 2003

Changes appear to loom for the international bond market. Not that long ago, governments were talking balanced budgets or operating surpluses. With that in mind, it was predicted bond supplies would dwindle overall.

For some countries, bonds would be issued mainly to keep open a liquid market. Australia was one country officially examining what the incredible shrinking sovereign debt market meant for its own bond issuance.

The odd one out was Japan. It has run a so far abortive and probably world record Keynesian stimulus campaign, offering bonds to shore up massive government subsidies to ailing corporations. Results have been negative. Economic benefit has failed to materialise. Japan's credit rating has slumped.

The Bank of Japan has become the largest buyer of its own government's new bond issues. Last year a bond issue was cancelled for lack of sufficient takers. Japanese bonds are now in gross oversupply and cause concern in respect of their weightings in index funds.

The US looks set to join Japan in a bond-printing spree. In one of the ironies of its political life, a supposedly spendthrift Democrat President Bill Clinton oversaw balancing of the budget and reduction in the need for bond issuance. Since then, a supposedly fiscally conservative Republican President George W Bush has trashed the budget. Goodbye balance or surpluses. Hello years ahead of huge deficits and US bonds printed to pay for them.

It is conventionally prudent to boost government spending during times of economic downturn. A shortfall in taxes is made up for by printing bonds. But the Bush administration looks as if it has got itself into a fiscal cul-de-sac. It already had a slowing economy and falling tax take to deal with. It introduced tax cuts.

Then came September 11 and a huge boost in national security spending. Now it is impending war on Iraq. President Bush has announced even more tax cuts, plus extended welfare and drug subsidies for the elderly. It takes a lot of bonds to cover the vast expenditure implied on a smaller tax base.

There has been fierce debate within the Republicans between those who think tax cuts stimulate economic growth and those who argue that deficits are fiscal cancer. The tax cutters assert lower tax rates mean higher total tax take and thus the deficits will be moderated. The anti-deficit sceptics remain to be convinced.

Tax increases to fund increased government spending during a downturn do not seem to work, judging by the Japan experience. To counter its slump at the end of the bubble economy, sales tax was increased from 3% to 5%. The increase was a factor in the persistent collapse of Japanese consumer spending.

The re-elected Schroeder government of Germany campaigned on a freeze in taxes yet broke its promise by announcing tax hikes to assist the moribund economy. The government's popularity plummeted and the economic outlook seems poorer than before.

In the UK, Treasurer Gordon Brown wants to boost taxes and government spending, particularly on health, when it seems London could pull the country down into recession (NBR, Jan 24).

The next few years are going to be an interesting laboratory for tax and deficit experimentation.

On the tax side, it seems to come down to how hard to squeeze the golden goose for the required amount of fiscal eggs. Some seem to favour a soft obstetric hand such that the goose willingly parts with its clutch. Others appear to plump for outright disembowelment. On the deficit side, it will come down to how many investors want to place their nest eggs in the sovereign bond market.

Substantial expansion of the government bond market could have implications for the possibility of the economic recovery it is supposed to finance. Arguably, government bonds crowd out private sector financing through debt or equity issues.

A private sector starved of capital will be an enfeebled taxpayer for bond repayment. If sovereign credit ratings slump on suspicion of difficulty in repayment, the cost of capital could increase to the private sector, making many types of businesses uneconomic and further impact on tax take.

A lot is at stake with the Bush administration's decision to hazard substantial and long-running deficits. Whether it is correct will be shown conclusively over the next few years.

Certainly it will be the largest fiscal experiment of its type ever conducted.

In the meantime, the bond market is undergoing significant change as it shifts from shrinking to growing supply. The weighting of US bonds is likely to increase, perhaps to the point where they attract the same sort of cautious supping with a long spoon as Japanese bonds inspire.

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