Predictions about the future

The WSJ and other conservative outlets are fond of claiming that either government spending and/or low interest rates are raising the risk of inflation and default. They claim that "bond vigilantes" are driving up long-term interest rates because they expect inflation or default in the long-term future.

Paul Krugman explains why this is bunk:

As many people have noticed, the term spread — the difference between short-term and long-term interest rates — is very high. The last time I wrote about this, people were taking this as proof that the economy would recover soon. Now they’re taking it as bad news — as somehow suggesting fears of default. But there’s a reason for a high term spread that has nothing to do with either explanation...

If the economy improves, short rates will rise; but if it worsens, well, they’re already zero, so there’s nowhere to go but up. This implies that there has to be a positive term spread.

Now, this spread could be fairly small if people expected the economy to remain in the dumps for a long time; see Japan. What the large spread now tells us is that the US economy is in the dumps now, but that investors see a reasonably good chance of a strong recovery in the not-too-distant future. That’s good news, not bad news.

More broadly, on the risks-of-default thing: surely if investors were growing worried about US ability to honor its debts, they would be worrying about a breakout of inflation as well as or instead of default per se. But we can track that by comparing interest rates on ordinary bonds and inflation-protected bonds. What we see is that from 3/17 to 3/30 — the period that inspired all those recent scare stories — the nominal interest rate on 10-year bonds rose by 26 basis points; the real rate rose by 28 basis points. So expected inflation actually declined, marginally.

This is not at all what you’d expect to see if markets were pricing in fears about the US ability to repay. It is, on the other hand, exactly what you’d expect to see if markets slightly upgraded their hopes of recovery.

So markets expect the U.S. to recover and not to default.

But I can't really get very upset at the WSJ for wringing their hands about a U.S. sovereign default...because even if the markets aren't worried, I'm still worried. The thing about markets is that they change their expectations really fast. Here's the market odds on health care reform passing:









Using market expectations as a predictor of what's going to happen to the U.S. debt 10 years in the future thus looks a bit ridiculous. If the U.S. ever does default on its debt, expect a similarly abrupt spike in market expectations of default.

Controlling health care costs, raising taxes, and focusing on fiscal responsibility in general are all still very important things to do.