A Bad Connection in the Markets

A Bad Connection in the Markets
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At first glance, news that Standard & Poor's has placed the AAA rating of the United Kingdom under review for a possible downgrade would seem to have no real connection to the fact that U.S. bond yields jumped to six-month highs.

But that would be a mistake.

In fact, these and other recent developments likely reflect an increasingly widespread fear among analysts, creditors, and fixed-income investors that a growing number of governments no longer view sound finances as a key policy goal.

Since the turn of the year, five countries -- Japan, Ireland, Spain, Portugal, and Greece -- have had their formerly top-notch credit ratings cut by S&P, Moody's, or Fitch amid expectations that faltering economic growth, burgeoning public spending, and an increasing reliance on borrowed money has undermined these countries' financial prospects.

In general, deteriorating credit ratings translate into higher borrowing costs. That is not a welcome development when government budgets are already under pressure and public sector demand for credit is expanding rapidly around the globe.

And while some might argue -- with good reason -- that rating agencies' opinions shouldn't matter all that much considering how badly they did when it came to evaluating the creditworthiness of institutions and an array of financial instruments during the recent credit boom, global credit markets are also telling an alarming story.

Around the world, despite -- or, perhaps, because of -- the efforts of central bankers and legislators, long-term bond yields in many countries are at or near six-month highs and yield curves -- essentially, the gap between long and short-term rates -- have been widening, in some cases dramatically.

Taken together, this combination can be seen as a clear sign that investors are starting to worry about the prospect of sovereign delinquencies or defaults, or the threat of serious inflation -- or both.

If history is any guide, it would not take much for such fears to begin feeding on themselves, eventually translating into a widespread vote of no confidence that will leave many governments -- and their citizens -- exposed to myriad risks, not least of which is an inability to fund essential spending on infrastructure and defense.

Yet despite these warning signs, many mainstream economists and policymakers here and elsewhere continue to push for more and more spending, bailouts, rescues, and borrowing than the already substantial amount we've seen so far -- without a coherent plan, accountability for how the money is being spent, or a clear sense of what the endgame is.

In their view, the need to address near-term economic woes far outweighs the longer-run implications of what might be described as an imprudent course of action. Even among those who are alert to the risks posed by the orgy of government spending, there is a belief that the strategy can be easily reversed once the time is "right."

Unfortunately, the track records of policymakers and politicians, in the United States and in other countries, have proven they are wholly inadequate when it comes to making such assessments, even if one only takes more recent events into account.

Moreover, assuming that those in charge somehow figure out when they've "solved" whatever problem it is they are worrying about -- that is, if they actually know themselves -- the markets are likely to be anything but accommodating.

At that point, in fact, there's a very good chance that we will see the loss of confidence that is already gaining pace in a host of countries evolve into a full-fledged run on the banks -- or, in this case -- the currencies and the bond markets of those governments that decided deficits and debts don't matter in the short run.

By then, everyone will understand why today's seemingly unrelated events are so deeply connected.

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