Duncan’s Economic Blog


Posted in Uncategorized by duncanseconomicblog on March 13, 2009

I worry about deflation. So does hedge fund manager Hugh Hendry. Who is a big buyer of government bonds. Liam Halligan who writes for the Telegraph disagrees.

They had something of a ‘clash’ on CNBC this week. Worth watching.


I’m not worried

Posted in Uncategorized by duncanseconomicblog on March 13, 2009

I share Hopi’s concern over reports that the Chancellor might be watering down any fiscal stimulus at next month’s budget. Over the weekend (as I really do lead such an exciting life), I hope to set out my own thoughts on what is required. But am I aware that several of my readers, and you know who you are, are going to start complaining that everything I suggest is unaffordable and the government should concentrate on cutting public spending and taxes. So I hope to deal with some of those points preemptively.

In December George Osborne tried peddling the line that the UK government was now perceived by the markets to be more likely to default than ever before:

“George Osborne has slammed the Government after the market view of the UK’s default risk reached a record high.”

Thankfully the story didn’t run too far as any press release which includes the term ‘credit default swap’ is unlikely to be an instant hit. Guido too has ran with this theme, stating that:

“markets now see Britain as a bigger credit default risk than McDonald’s Corp”

Both of these analyses are premised on the idea that ‘credit default swaps’ are the best indicator of perceived credit risk. I don’t share this premise.

I could bore you all to death with the problems of using the CDS market to measure anything, and at some point I probably will, but for the moment I highly recommend this.

Some excerpts:

Like many parts of the financial system these days, credit default swaps are so complicated, simple bankers couldn’t have created them.

In the 1990s, he says, he was a fan of credit default swaps.
“But by about 2003-2004, I was starting to get nervous,” Das says. “I could see the market had gone from a very legitimate purpose to something which was much more racy and interesting but also much more dangerous.”

He says along the way, it stopped being insurance.

“The line between investing and speculation or gambling in financial markets is always a pretty gray one,” he says. “And speculation is always a motive.”

So, rather than using one of the more arcane areas of modern financial innovation to value the perceived credit worthiness of the UK government, I prefer to use the oldest. How much does it cost the UK government to borrow money? (I.e. what is the yield on a 10 year government gilt (bond)?)

The answer is, not very much.


Would ‘the market’ be charging the UK government around 3% per annum to borrow money if it thought it wouldn’t pay it?

I am not alone in thinking the government bond market is more efficient than that. A certain Paul Staines once wrote:

Just as stock markets reward successful companies, government bond markets reward prudent governments and punish profligate ones. If a state overspends it will cause the cost of its borrowing — and your taxes — to rise. This costs votes and is a powerful means by which capital (in the Marxist sense) restrains politicians.

Well the bond market certainly isn’t punishing this government.

In the final analysis the valuation of any bond, and hence the interest rate that should be charged, depends upon the issuer’s ability to generate cash to meet those interest payments. Warren Buffet, arguably the world’s most successful investor, says that when examining any potential investment he likes to see a ‘deep moat’, some attribute that will protect future cashflows. The UK government has a pretty successful franchise, the ability to levy taxes.

If government bond yields start to rise drastically I’ll be concerned about the UK’s credit worthiness, until that point I’ll ignore the alarmists.