IMF's Curious Conclusion about Debt/GDP and Bond Yields

November 15th, 2012
in Op Ed

Long-Run and Short-Run Determinants of Sovereign Bond Yields in Advanced Economies (except Japan)

by Dirk Ehnts, Econblog101

euro-currency-bills-150x150The IMF has a new working paper out, and the title is the one above except for the term in brackets. As I have often argued here in this blog, I agree with Richard Koo in that Europe is in a balance sheet recession. This means that the private sector wants to deleverage and does not want to borrow more, so government is free to borrow without creating inflation. Nevertheless, in a new paper the summary reads like this (my highlighting in bold):

Follow up:

We analyze determinants of sovereign bond yields in 22 advanced economies over the 1980-2010 period using panel cointegration techniques. The application of cointegration methodology allows distinguishing between long-run (debt-to-GDP ratio, potential growth) and short-run (inflation, short-term interest rates, etc.) determinants of sovereign borrowing costs. We find that in the long-run, government bond yields increase by about 2 basis points in response to a 1 percentage point increase in government debt-to-GDP ratio and by about 45 basis points in response to a 1 percentage point increase in potential growth rate. In the short-run, sovereign bond yields deviate from the level determined by the long-run fundamentals, but about half of the deviation adjusts in one year. When considering the impact of the global financial crisis on sovereign borrowing costs in euro area countries, the estimations suggest that spreads against Germany in some European periphery countries exceeded the level determined by fundamentals in the aftermath of the crisis, while some North European countries have benefited from “safe haven” flows.

So, let us take a look at Japan, the only advanced economy that had a collapse in both real estate and stock markets for the last 20 years. The slide if from Richard Koo’s Nomura presentation:

So, government debt moves up from 40% to 140% of GDP. That should, according to the IMF study, increase government bond yields by 200 basis points, which is the same as 2%. Being very fair to the IMF, let us look at the yield of 10-year government bonds of Japan. They went down from about 7 to 1.5%, not up to 9% as predicted by the study.

If you search for “Japan” in the IMF paper, it comes up 4 times, 2 times in footnotes and once in the main text and in a table. There is a ‘Japan dummy’ mentioned (see Table 21, for example).  I can quite imagine who the ‘Japan dummy’ is here.

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About the Author

Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101. Curriculum Vitae.

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  1. Explorer says :

    Japan's high public debt and low bond rates are an inconvenient truth.

  2. Derryl Hermanutz says :

    What part of "savings glut" does the IMF not understand?

    In order for a government or private sector actor to spend more than they tax or earn, they must first acquire the money by borrowing. Notwithstanding that the shadow banking system now creates its own money via derivatives, rehypothecation, etc, the money that public and private sector "deficit spenders" spend originates as the creation of financial credit by a bank. The borrower acknowedges his "debt" to the bank by issuing a bond or signing a promissory note promising to pay interest and to repay the loan principle when the bond or note comes due. Money that has been borrowed and spent into the economy, but which has not yet been taxed or earned back out of the economy to repay the debt, is the economy's "moeny supply".

    The money supply is held to a small extent as "cash" in people's pockets or under mattresses or in plastic wrapped bundles used by druggies and other "covert operatives". But the primary form in which the money supply is held is as bank account balances and investment account balances.

    Some of these bank account balances are in "current accounts" where the money is readily accessible to its present owner and can be transferred to others by check, bank draft, etc. to pay day to day expensess. But the bulk of the money is held in longer term accounts where it is people's "savings".

    We need to remember that all of the money originated as a bank loan or bank purchase of a new government bond. Which means that the money supply only exists in the economy because
    borrowers have not yet earned or taxed that money back out of the economy to repay their bank loan.

    The creation of a bank deposit when a bank buys a bond or makes a loan is the creation of our "money". The repayment of the loan brings the "credit" (the bank account balance) and the "debt" (the obligation to repay loan principal) back together on the lending bank's balance sheet, where the positive number (the account balance) cancels the negative number (the debt) leaving no money and no debt.

    Our money is created as a bank balance sheet equation where the positive and negative numbers are "temporarily" separated and become a quantity of money and an equal quantity of debt. A bank loan separates zero into equal positive and negative numbers, money and debt. Repayment returns the money and debt to zero where it began.

    So the flip side of the megteillions of debt that some governments and some private sector borrowers stillowe, is that the megatrillions of "money" that they borrowed and spent is still out in the economy as the money supply. Those parties' debt is the other parties' current account balances and savings.

    Savers want to lend out their savings to earn a rate of interest, a "return". But all of the borrowers have reached their credit limit and can't borrow any more money to deficit spend. And where the economy had previously been enriched by the spending of all the borrowed money, it is now being impoverished by the repayment of all that debt. Debtors are having a hard time taxing and earning because there is not as much spending tomtax and earn. Debtors are trying to deleverage their personal balance sheets. We are in a "balance sheet recession".

    In this environment of constrained spending businesses will not invest to maintain or increase their outputs because spending is "demand" for business outputs and spending is down. So businesses lay off workers and reduce their outputs and hoard cash or pay down their own debts rather than spend more as "investment". Businesses' top line revenues are down so they cut costs to preserve their profitability and/or to preserve their personal solvency.

    But there is megatrillions of savings out there looking for profit generating investments in order to earn a return. Classically, "inflation" is caused by too much money chasing too few goods. We had plenty of inflation during the tech bubble and the real estate bubble. $Trillions were borrowed and spent by some people and those very same trillions were earned and saved by other people.

    But the go-go days of money supply inflation are behind us and now we're in the debt deleveraging deflation. Except this time, rather than let creditors lose their money once it became clear that borrowers could not repay, we have chosen to bail out the creditors who are holding all those worthless (because unpayable) "promises" to repay loan principal. So rather than writing off all the money that creditors thought they had coming, and taking their own moneynto cover the bad loans that they made, we have left all that money out in the economy where it is now competing for a woefully inadequate supply of profitable investments. Now rather than too much money chasing too few goods which causes inflation of the prices of "consumer" goods (flat screen TVs, etc) and consumer assets (owner occupied houses and condos), we have too much money chasing "investment" goods and assets.

    So while monetary effects are deflating CPI prices (though commodity inflation is still causing cost-push inflation even while we have demand-pull deflation) and consumer real estate prices, the flip side of those monetary effects is causing investment price inflation. So the prices of bonds and equities and other investment goods are being inflated by too much savings chasing too few investment goods, and competition for those scarce investment goodsmlowers their yield.

    In this balance sheet recession coupled with this savings glut from deciding not to bankrupt the insolvent creditors, interest rates on investable money are not being "artificially" suppressed by the Fed or other culprits. Low interest rates and low investment yields is a direct consequence of too much savings chasing too few investments which creates our current environment of investment price inflation. "The market", not the Fed or others who "interfere" in markets, is creating low interest rates.

    If Dirk and I can read and understand Richard Koo, why can't the IMF?



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