Real growth can cut risk from public debt

The following comment by me appeared in the latest Fund Strategy (1 June). It is more technical than most of my articles but is an important component of the discussion on the global economy.

Last week saw a hiccup in the US Treasuries market. Whether the hiccup will turn into a fit remains to be seen.

Yields on 10-year Treasuries jumped on Wednesday. Their current rate is not particularly high, but it could be a sign of a rising trend. Given that the American government bond market is the benchmark for global bonds, it is an important development to watch.

Brad Setser, a fellow at the Council on Foreign Relations in New York, argues that the surge was a result of a combination of rising supply alongside falling demand from private investors. There is also concern about the rising level of public debt in America.

There is even talk of the return of the “bond vigilantes”. These are investors who demand a higher return on US Treasuries in return for the risk of investing in an asset class vulnerable to inflation. Their actions have previously played a role in encouraging governments to keep credit growth in check.

To understand the significance of these fears it is necessary to examine the chain of factors through which problems become manifest.

The immediate concern is inflation. Bond investors clearly dislike it because it erodes the real value of their assets. That is why they demand a higher compensation to invest in bonds in inflationary times.

But the factor most directly stoking up inflation is the rising supply of credit. High public spending in particular is seen as embodying the risk. In the short term, public spending was seen as necessary to stabilise the financial system and the economy. In the longer term, it could bring about strong inflationary pressures.

Unfortunately, this is often where the discussion stops. Conservatives demand sharper curbs on ­public spending while Keynesians tend to be more sanguine about it.

What is missed is that the massive level of state intervention in the economy is itself the result of an underlying economic weakness. The stronger the dynamic to economic growth, the less need there is for debt artificially to prop up activity.

Growth based on credit expansion is highly vulnerable. It risks a financial shock, such as that of recent months, or high inflation to readjust to economic reality. What is needed is real growth based on genuine innovation. Such growth should provide the basis for a solidly based recovery that is less prone to financial instability.

Surging inflation and bond vigilantism should be seen as symptoms of a weak economy rather than problems in themselves. Dealing with them on a financial level, rather than in relation to the real economy, will not resolve the key weaknesses.