With U.S. bond yields at near all-time lows, it is tempting to believe that large U.S. government debts and deficits do not put the United States at risk. Historically, governments that ran into debt problems had high yields on their securities, so it makes sense to equate low yield with fiscal responsibility. But, while it may be intuitive, it is fundamentally incorrect.
The risks often associated with a large debt are that the government will default on that debt, or they will crank up the monetary printing press to pay for the debt, causing high levels of inflation. However, the government may act responsibly by making (ever increasing) interest payments and paying down debt through increased taxation and reduced government expenditure. In doing so, they slow economic growth, as higher taxes deter private sector investment and crumbling public-sector infrastructure will slow productivity growth. Nominal interest rates in a country with a stagnant economy and low levels of inflation would be quite low, despite high levels of government debt.
There is always the possibility that the U.S. government will try to inflate the debt away. How concerned should we be with long-run inflation? In my view, not very. Given the demographics of the United States, the disproportionate voting clout held by seniors living on fixed income and memories of the 1970s inflation will be a last, not a first, resort.
Low bond yields do not necessarily mean that markets share my optimism on inflation. U.S. bond prices could continue to be high (and yields low) in the presence of inflation risk from high government debt if other countries have similar risks. Holders of U.S. government bonds gain little advantage switching to Japanese or U.K. bonds so prices for those bonds can remain high. Given the relatively flat shape of the yield curve, the stagnation hypothesis is a better fit for the data, but the possibility for higher levels of inflation in the long-term should not be dismissed out of hand.
One unresolved question is why anyone would buy bonds – either government or corporate – in a world where inflation was expected to rise? Why not buy an asset that would be expected to rise with inflation, such as equities, commodity futures or classic video games? There are the standard reasons of volatility, liquidity and transaction costs that make these imperfect substitutes for bonds. Then there is the role of government regulation; financial institutions cannot simply swap bonds for oil futures or copies of Frogger for the Atari 2600 and meet OSFI regulations. Given the sheer size of institutional portfolios, these requirements cannot be overlooked.Report Typo/Error