The Bond Market Has Spoken: Austerity Is A Loser, And So Are Reinhart And Rogoff

Carmen Reinhart, a professor at Harvard University, speaks at the Bloomberg Markets 50 Summit in New York, U.S., on Thursday,
Carmen Reinhart, a professor at Harvard University, speaks at the Bloomberg Markets 50 Summit in New York, U.S., on Thursday, Sept. 13, 2012. The conference brings together the world's most influential leaders in finance, business and government to discuss the global economy. Photographer: Jin Lee/Bloomberg via Getty Images

Forget about Reinhart and Rogoff, and whether they're right or wrong about the horrors of too much government debt. The bond market has spoken: There's no such thing as too much government debt.

Interest rates around the world are near record lows, and bond investors just can't buy enough bonds, despite the sort of massive government borrowing that Harvard professors Carmen Reinhart and Kenneth Rogoff and other debt-and-deficit scolds have warned about for years. That means the only people in the world who believe their tireless warnings are those same debt-and-deficit scolds, despite all evidence.

Reinhart and Rogoff's austerity-justifying 2010 paper, "Growth In A Time Of Debt," strongly suggests that economic growth slows dramatically once government debt reaches 90 percent of gross domestic product. But it doesn't exactly explain why that might be. That paper has been pretty thoroughly debunked by now (though Reinhart and Rogoff disagree). But the general theory of what happens when you have too much debt -- espoused in other venues by Reinhart and Rogoff and by fellow travelers such as Gregory Mankiw -- is that government borrowing "crowds out" borrowing by the private sector. That pushes interest rates up and stifles investment and growth.

Except, in the real world, the exact opposite thing has happened. As the U.S. government's public debt has ballooned from 65 percent of GDP in late 2007 to more than 100 percent of GDP in late 2012, the interest rate on 10-year Treasury debt has collapsed, from about 4.5 percent to about 1.7 percent.

In other words, even as the government has borrowed $7 trillion in five years, bond investors are so hungry to lend it even more money that they have slashed the interest they charge in half.

And it's not just the U.S. government that is borrowing wantonly without consequences. Bloomberg points out that some $20 trillion in global government debt yields less than one percent.

Japan's debt exploded last year to nearly 212 percent of GDP, but the government has to pay almost no interest costs on that debt: Japan's 10-year government bond pays just 0.6 percent interest. Japan's debt load is more than twice as large as America's, and its borrowing costs are less than half as much.

And despite all of this borrowing, the market has a fever, and the only prescription is more bonds! Even as stock prices rise to record highs, investors have been steadily pumping money into bond funds since the financial crisis, seeking the relative safety of a fixed investment income. Central banks, in an effort to keep money flowing through their economies, have been mopping up a lot of the government debt around the world, adding to the demand for bonds. And soon the biggest banks around the world are going to have to hold a lot more safe government debt in order to build up their defenses against future crises. Bloomberg suggests that there may not be enough bonds to meet all of this demand.

And how about that terrifying "crowding out" that is supposed to happen when governments borrow all that money? Also not happening. Companies have borrowed nearly $1.6 trillion in the past five years, according to Federal Reserve data, at record-low interest rates. When interest rates are so low, it only makes sense to borrow money, even if you don't have a burning need for the cash (the total amount of cash and other liquid assets on corporate balance sheets is about $1.8 trillion, according to the Fed). Apple Inc. just announced that, despite having $145 billion in cash, it will borrow money for the first time in its history.

Austerity fans clearly don't think they've lost the battle. Reinhart and Rogoff have backed away from austerity a little, by saying it's not the only solution to high government debt. But they clearly still think of high debt as a problem, rather than a temporary symptom of slow growth.

Others are charging full-steam ahead into the austerity that Reinhart and Rogoff's paper helped justify. Greece just passed a law allowing it to lay off 15,000 civil servants, at a time when its unemployment rate is 27 percent. It did this in order to win more bailout money from its European paymasters, who have forced harsh austerity measures on the country in exchange for cash. Though some European politicans are reconsidering that approach, Germany and other countries are still pushing it.

Many of these same austerity fans are also believers in the idea of an efficient market. For some reason, they're not believing what the bond market is telling them.