I started writing a post the other day about how Niall Ferguson was just embarrassing himself by claiming victory in his dispute with Paul Krugman, but I never got around to finishing it. Luckily, Martin Wolf was not so easily distracted, and has delivered an epic takedown of Ferguson. In short, Ferguson claimed that monetary and fiscal expansion were "contradictory," because "if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up." Krugman correctly pointed out that this was a ridiculous claim. Ferguson, being perhaps the most egotistical commentator in the world, subsequently declared that the recent rise in 10YR Treasury yields had "settled" the dispute in his favor, and wrote an entire op-ed in the FT congratulating himself. As Wolf notes, while 10YR Treasury yields have risen recently, they're still well below their long-run average:
So what is the disagreement? Prof Ferguson made three propositions: first, the recent rise in US government bond rates shows that the bond market is “quailing” before the government’s huge issuance; second, huge fiscal deficits are both unnecessary and counterproductive; and, finally, there is reason to fear an inflationary outcome. These are widely held views. Are they right? The first point is, on the evidence, wrong. The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets. At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October (see chart). Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real. What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone. Hurrah! ... If inflation expectations are not worth worrying about, so far, what about the other concern caused by huge bond issuance: crowding out of private borrowers? This would show itself in rising real interest rates. Again, the evidence is overwhelmingly to the contrary.The most recent yield on Tips is below 2 per cent, while that on UK index-linked securities is close to 1 per cent. Meanwhile, as confidence has grown, spreads between corporate bonds and Treasuries have fallen (see chart). One can also use estimates of expected inflation derived from government bonds to estimate real rates of interest on corporate bonds. These have also fallen sharply (see chart). While riskier bonds are yielding more than they were two years ago, they are yielding far less than in late 2008. This, too, is very good news indeed.