Are we at the mercy of global financial markets, the so-called Bond Vigilantes so frequently invoked by Wall Street analysts? Do modern governments quake when unelected financiers threaten to wreak havoc on their economies? To a certain degree, the answer to both of these questions is obviously—even trivially—yes.
But having some power is quite different from being all-powerful, and we need to understand the difference. The human beings who interact in the financial markets on Wall Street and around the world can and do change the options that politicians face. Sometimes. That can be good or bad, but either way, we would do well to understand how far that power does and does not extend.
Here, I will discuss the power and limits of financial markets by looking at three examples: (1) the disastrous, brief tenure of former British Prime Minister Liz Truss, (2) the markets’ response (more accurately, their lack of response) to the US federal debt, and (3) the possibly cataclysmic fallout if Republicans retake the majority in either house of Congress in the midterms and then refuse to increase the federal debt ceiling.
Political Power and Its Counterweights
In the continuing turmoil of modern politics, once-stable countries like the United States and the United Kingdom are suddenly the objects of richly deserved ridicule. Americans were ruled for four years by a former game-show host, a man who now commands the loyalty of people who think that “Do your own research” is a synonym for “I can do whatever I want.” Britons, meanwhile, are watching their political system circle the drain. What is not to mock?
Being ridiculous is not necessarily funny, of course, and both countries face rising dangers from political extremism and economic self-damage. The UK’s fateful decision to vote for Brexit did not cause an immediate depression, but it is now clear that the country will be permanently poorer than it otherwise could have been, as its refusal to accept its diminished importance is already causing predictable (and predicted) economic harms. Meanwhile, the conservative party in the United States would rather tank the economy and blame the Democrats than serve the people they claim to represent.
A large part of the problem in both countries, mirrored to varying degrees in far too many other nations around the world, is that their political systems have gone off the rails. At a deep level, conservative politicians in America and Britain do not want to be accountable to the people, so they are making the people irrelevant. Democracy can be so inconvenient for ideologues who would like to wield power without facing consequences for the damage that they inflict on their citizens.
But there are other sources of countervailing power that can bring a wayward government to heed. In other eras, churches in the US and the UK were powerful enough to directly influence policy. That is still true to some extent, although it has never been a particularly comforting thought that an even less democratic and almost wholly unaccountable sector of society could wield such power. The point, however, is that church and state often did rein each other in.
Another source of power that can stop even the least politically accountable politicians from acting without consequence is the financial markets. (Those, too, are undemocratic.) Poorer countries see this up close almost every day, with constant worries about global financiers’ reactions to such countries’ borrowing and monetary policies, along with other potential sources of instability.
The short version of the conventional wisdom is that “the markets will punish you” if a government should try to ignore the supposedly immutable fundamental realities of economics. And at some extreme level, this must certainly be true. If, for example, a government announced that it was going to allow all of its citizens to retire early and then give them pensions fit for monarchs, no investors in the world would be willing to put their money into that country. Absurd policies have consequences.
This reality, however, merely says that it is possible to go too far. That people can kill themselves by overeating is not an argument against consuming food, just as we should engage in physical exercise even though it is possible to die from pushing our bodies beyond their limits. There is a large middle ground within which people can make reasonable choices, just as different countries can make different decisions about economic policy without going too far.
The question is: How much is too much? In a Verdict column on October 13 of this year, I mocked the argument that the financial markets will ruthlessly punish the US government for supposedly borrowing too much money. The logic by which this is supposed to work is actually rather amusing.
Those Neurotic Markets
Conservatives often talk about “the markets” as though they are needy collectives of worried and fidgety people who crave nothing so much as confidence. What does it mean to give markets confidence? In truth, anti-government ideologues use the faceless markets as a vehicle to advance their reactionary policy preferences: cut spending for the oh-so-undeserving poor, slash taxes on the rich, allow businesses to exploit the weak (and the environment), and so on. Any move by liberals in other directions, we are told endlessly, will harm markets’ confidence.
In that column, I noted that those of us who doubt the awesome power of The Markets have taken to characterizing the conservative story as an appeal to an erratic sprite that we call the Confidence Fairy. One merely needs to turn on any financial news channel on any given day to hear an overpaid analyst claiming that “market confidence is up” or “the government is destroying market confidence,” with consequences sure to follow.
Why do we mock that idea? Because (to mix children’s stories) the people who want us to pay heed to the Confidence Fairy are the boys who cried wolf, again and again and again. By their lights, it is always true that the government is one liberal decision away from destroying markets’ confidence and creating hell on earth. As I wrote in that earlier column:
The problem is that the Confidence Fairy—less fancifully known as bond vigilantes—is often invoked but rarely seen. We spent the entire Obama era being told that Democrats were undermining confidence in the financial markets and that interest rates would inevitably rise while inflation ran riot, but it never happened.
I wrote those words while criticizing the claim that US federal debt is going to lead the Confidence Fairy/bond vigilantes to punish us. I will return to that specific example below, but I will turn first to the experience of the hapless Ms. Truss in the UK, an experience that validated what I wrote in the very next sentence of my October 13 column: “Just because something has not happened yet, however, does not mean that it could never happen.”
The British Bond Vigilantes Had Quite a Month
As the citizens of the UK learned to their dismay, market punishment of foolish government policies can definitely happen. What went wrong for the short-lived Truss government? Basically, two versions of conservative market idolatry collided. It was not clear in advance, however, which one would win.
Truss and her government came into office at the end of the summer and, after a two-week pause for national commemorations of the passing of Queen Elizabeth II, announced that they would cut taxes (especially on the rich) and increase spending, the latter to gain political support by helping Britons afford to pay for higher heating and other costs.
Even with the sops to the non-rich, this was a very regressive agenda. A news article in The New York Times blithely referred to Truss’s policies as “a free-market fiscal agenda,” but this is a rather odd way to describe a radical increase in government borrowing, because it contradicts the countervailing conservative faith in the idea that government borrowing is bad. If conservatives are in favor of free markets, and if a government is forced to go into the financial markets to borrow large sums of money to finance deficits caused by tax cuts, then that does not look like Econ 101’s version of an economic system that thrives while a hands-off government nods approvingly from a safe distance.
This is, as I noted above, the clash of two conservative visions. The first vision, based on regressive tax cuts, is also known as trickle-down economics. In its most extreme variation, called supply-side economics, the tax cuts are said to be not merely stimulants to private-sector activity but so wonderfully stimulative that the tax cuts are more than outweighed by the increase in economic activity. Conservative financial market types, then, should presumably have loved the return of policies once advanced by Margaret Thatcher and Ronald Reagan, which should have made the bond vigilantes and the Confidence Fairy happy.
The alternative conservative vision, however, arguably prevailed in this case. The UK and global financial markets lost confidence in the Truss government overnight, pushing the value of the British Pound to record lows and forcing the Bank of England to intervene—proving once again that government bailouts can save an economy—and forcing Truss to reverse her policies within days. Showing a level of shame and responsiveness to accountability unknown in the US, Truss soon walked away.
Citing the British economist Simon Wren-Lewis, however, Paul Krugman argued last week that the problem—the real reason that the bond vigilantes summarily dispatched Truss—was “that financial markets were responding in large part to increased uncertainty, which was in turn largely a reflection of political uncertainty. The Truss economic plan was obviously unsustainable politically, but it wasn’t clear what would come next.”
Krugman further points out that, unlike my example above of the small, poor country that is punished by the Confidence Fairy if its government acts irresponsibly, the independence of the Bank of England gave everyone confidence that the UK is not on a slippery slope toward becoming the proverbial banana republic. Markets had indeed lost confidence, but not in the British government’s ability to finance itself. They thought that the politicians had become unhinged.
Why does that matter? If the standard bond vigilante/Confidence Fairy story were true, the problem would be that the government was about to borrow too much money. Krugman is saying that the punishment was not meted out due to the borrowing that Truss’s policies would have required but because the entire British political system was in turmoil. Oddly, of course, the result of the vigilantism was to create still more political turmoil, leaving Truss with the shortest term in office of any British Prime Minister in (a very long) history.
The US National Debt and the Revenge of the Markets
The contrast with the Republicans’ fearmongering about federal debt in the US could not be clearer. I wrote my Verdict columns earlier this month in response to a contrived effort by the mainstream press and anti-debt conservatives to get everyone to panic because gross federal debt now exceeds $31 trillion. Why was that supposedly bad? As I noted above, the story ultimately comes down to the Confidence Fairy … as always.
The problem for conservatives is that this story (the claim that increases in the US federal debt are going to invite the fury of the markets) offers no triggering event. There is nothing about the number $31 trillion that should—or did—spook the financial markets. Yes, that is a big number to most people, but it is easy to evoke oohs and ahhs with any number ending in “-illion.” Moreover, there is no clear explanation why the financial markets care about the dollar amount of gross federal debt, which is itself a meaningless number.
Most importantly, it was not a surprise to any financier who cares to know about these things that we reached the $31 trillion level this month. The debt number rises, just as the nation’s income rises, and it is likely to reach $32 trillion next June and $33 trillion sometime in 2024 or 2025. The markets could barely stifle a yawn at the attempts to make a big deal out of hitting an arbitrary “historic” level of debt.
Back to the Debt Ceiling
I do not want to go too far into the weeds about the federal debt ceiling statute, about which I have written at great length. I will, however, take this opportunity to point out that Republicans have announced plans to use the majorities that they hope to win in the midterm elections next month to refuse to increase the debt ceiling. If they do so, that will be exactly the moment when the Confidence Fairy will become a hyper-depressive basket case, and the bond vigilantes will run amok.
Why do they not care about supposedly out-of-control levels of debt, but they would go completely bonkers in the midst of a debt ceiling crisis? The two situations could not be more different.
Again, a government could go too far in committing itself to future borrowing, in which case the markets would react harshly. The fact is, however, that the US’s current and projected levels of debt are sustainable. Whatever financial players’ political preferences might be (mostly conservative and Republican), their investment decisions speak louder than their words.
By contrast, a debt ceiling crisis would cause a first-ever US default. The Treasury securities that represent the federal debt are valuable assets to the people and institutions who loaned some of their savings to the government. They expect to be paid interest and principal, in full and on time. They handed over their savings in the belief that this country is not a deadbeat—and for good reason, because the United States government has in fact never defaulted on its obligations.
If that changes, that is when the markets would strike back. What happened to the UK a few weeks ago will look like nothing compared to what would happen in case of US debt default. Because ours is the largest economy in the world, and because even the most cynical financial players both at home and abroad count on the US government to pay its obligations, the freakout will soon go global.
So yes, financial markets do have the power to damage an economy in reaction to bad political choices. The now-defunct Truss government offered a brief reminder—thankfully with limited damage—of what can go wrong. US debt is simply not on a path that would cause anything like that kind of reaction. But if Republicans want to prove that bad political decisions can destroy the US and the world economies, refusing to adjust the debt ceiling as needed is, without question, the best way to make their point.