Monday, January 23, 2012
Britain, Japan and low gilt yields, part II
Posted by David Smith at 01:45 PM
Category: Thoughts and responses

Jonathan Portes, director of the National Institute of Economic and Social Research (Niesr), has published a lively rejoinder to my piece yesterday on his blog, here, in which he suggests I tie myself "up in all sorts of knots".

Jonathan's also a bit sensitive about my suggestion that he has taken Niesr back to its Keynesian roots: he says he doesn't really think of himself as a Keynesian and hasn't changed its policy position. The argument I set out on Sunday was, I thought, very straightforward.

If you thought Britain's very low gilt yields were "just as in Japan a sign of economic failure, not success", as Jonathan originally wrote, then you would expect that the markets were anticipating a long period of economic stagnation and deflation for Britain, as in Japan. They are not, and neither is the National Institute, barring a very big change in its forecasts in the next week or so.

The markets do expect Bank rate to stay low, as he says, but that is rather a different point. The Bank of England, and other central banks, have decided that the appropriate response to the aftermath of a banking crisis is to keep official interest rates low, and the expectation is that they will continue to do so even as the recovery strengthens. One of the arguments for doing so in Britain, of course, is that fiscal policy is being tightened. I'm not at all sure this is a sign of economic failure, merely a reflection of banking and financial conditions. Sir Mervyn King has made clear that a key factor keeping rates low is the health (or lack of it) of the banking system.

This, by the way, is in contrast to the response of the Japanese authorities. Zero rates only came in in Japan once deflation had taken hold. The response of the Bank of Japan to the bursting of its bubble economy two decades ago was to raise interest rates, not lower them. It was one of the lessons we have learned from the Japanese experience.

Why shouldn't the government take advantage of low gilt yields and borrow to stimulate the economy, as Jonathan suggests? Because, in my view, these things are a lot more finely-balanced than he allows. A Plan B fiscal stimulus would be seen by the markets and the ratings agencies as a powerful indication that the government was giving up on its fiscal strategy. Given how close the government came to breaking its fiscal rules in the Autumn Statement, it is hard to see the Office for Budget Responsibility looking benignly on any such policy shift. You can argue that none of this matters. In the real world, however, it does.

So, there should be no confusion. And if you want to draw a comparison with another country that has low government bond yields, why not Germany?

PS Jonathan has responded to my response on his website and appears to not know the difference between short-term and long-term interest rates. Very strange. My point was that, even if you accept his explanation for very low rates - that Bank rate will stay low - this does not imply Japanese-style stagnation and deflation. And it is perfectly possible for a country to have a low policy rate but very high government bond yields. Look at several eurozone members. Britain's low gilt yields reflect, as he has conceded, market confidence in the credibility of the government's fiscal plans.