Julia Nikhinson/AP Photo
Traders work on the floor of the New York Stock Exchange, September 13, 2022.
The antics of the British Conservative Party—where Liz Truss turned in by far the shortest term as prime minister in U.K. history—have been both hilarious and a welcome distraction from America’s wretched political news. But it’s increasingly clear that the way Truss went down, plus the inflation that has stayed stubbornly high for months now, has resurrected one of the demons of austerity politics: the dread bond vigilantes.
“During recent downturns, Congress helped cushion the blow by flooding the economy with stimulus checks and other relief,” Kate Davidson writes at Politico. “But doing that now while inflation is raging … would pile on even more debt and could rattle investors wary of policies that could stoke higher prices.”
The theory here is that should Congress pass some big spending bill without taxes to compensate, private investors (the aforementioned vigilantes) might balk at buying the resulting debt, and the government will be forced to cut back. On first glance, this appears to be what happened in the U.K.
But it’s just not true in either case. America in particular still has the greatest ability to borrow of any entity on the planet, and that will only become more true should a recession strike. It also possesses institutions that make it immune to a crisis of confidence in the debt market. The only way one can happen is if the Federal Reserve allows it.
It is true that London bankers were dismayed by Truss’s proposal of tax cuts for the rich, and that was a marked break with the banks’ traditional stance. But that wasn’t the whole story. On the one hand, as Toby Nangle explains on the Odd Lots podcast, another major driver of the crisis was a technical problem with big pension investors that touched off a death spiral in the U.K. government debt market, despite the fact that rising interest rates would be good for those funds over the longer term. (See here for a short explanation of the details.)
In other words, despite its stupidity it wasn’t Truss’s budget itself that threatened disaster, but rather how it triggered a potentially dangerous feedback loop hiding in a typically sleepy corner of the U.K. financial system.
On the other hand, the Bank of England resolved this specific crisis quickly and easily. Buying up a few billion pounds’ (backed by a promise to buy up to 65 billion) worth of U.K. bonds broke the doom loop and stabilized the market in a couple of days. Now the interest rates on U.K. government debt have fallen to nearly what they were before the whole mess.
The lesson here is that when a country borrows in its own currency—like the U.K. or the U.S.—it is impossible to have a crisis of confidence in the national debt, unless the central bank lets it happen. If private actors don’t want to buy U.S. Treasury bonds, leading to a feedback loop of skyrocketing interest rates, the Federal Reserve can simply buy them instead and end the panic.
When a country borrows in its own currency, it is impossible to have a crisis of confidence in the national debt, unless the central bank lets it happen.
Now, that is not to say that there are no limits whatsoever on buying bonds with printed money. Inflation is a real constraint here; the Bank of England’s quick purchases were an awkward about-face from its previous practice of selling off its stock of U.K. debt and hiking interest rates to reduce the supply of credit and fight price increases. But that was just a temporary move to ease a liquidity crunch and break a feedback loop. The point is that if a crisis of confidence is caused by a fear of running out of pound-based assets, controlling the ability to print pounds can fix such a crisis in moments. What’s more, the U.S. dollar is the global reserve currency, which creates a demand for dollar-based assets far stronger than that for U.K. debt.
In practice, inflation is highly likely to come down at some point over the next year or so. Supply chain problems in many areas are being straightened out, especially international shipping, and demand seems to be slackening across the board. Unlike the 1970s, there is nothing like the kind of organized-labor power that could enable wages to stay ahead of inflation. Meanwhile, Europe looks to be heading into a bad recession, and the U.S. could easily follow it within a few months. Should this happen, it is likely that inflation will fall even more, perhaps even into negative territory. In that case, it will be key to remember that without any price pressure, the government can print and borrow literally without limit.
But even if inflation stays somewhat high, what investors think will have nothing to do with how much the government can borrow. That has to do with the real resources available to the country, the level of inflation, and the behavior of the Fed. If chair Jerome Powell starts pointing to bond market fears as Alan Greenspan used to do when he was running the Fed, you’ll know that he’s attempting to push his own fiscal priorities while hiding behind Wall Street.
