Duncan’s Economic Blog

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.


4 Responses

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  1. tory boys never grow up said, on March 13, 2009 at 4:39 pm

    Absolutely correct – the CDS swap market is another market where the speculators have been at play. For those like Staines and Osborne who want to read too much into short term market fluctuations we should just point them at the oil price during 2008 and ask them how it reflects market fundamentals and demonstrates the efficiency of that market. We could then ask them why their beloved markets mispriced the risk on asset backed securities for so long – perhaps once they have answered those questions they can join the grown up economics debate.

    The one thing Darling does have to be a little wary of in the budget is that just because the reflation measures they have tried already don’t appear to have worked – it doesn’t mean that they won’t work eventually. Perhaps now Keynesian demand management is back in style they need to go back and look at some of the old studies about implementation lags and J curves and so on. Given the current febrile state of the markets – there could well be an overreaction when things start looking up.

  2. Gareth Parker said, on March 16, 2009 at 10:11 am

    The bond market would be a good indicator of the cost to government of borrowing… if the government wasn’t forcing its newly-nationalised banking subsidiaries to do the borrowing. Take them out of the mix and see what the yield would become.

  3. […] There’s an obvious market sign when credit becomes “unaffordable” – when the cost of our credit begins to rise. Are there signs of this at the moment? It seems not. […]

  4. […] net borrowing is still a lot lower than in the USA, Japan, France and Germany. Duncan’s not worried, and nor is Chris Dillow. An aggressive pursuit of government budget balance during the recession, […]

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