Date created: 28 November 1996
Last modified: 18 November 1997
Maintained by: John Quiggin
John Quiggin

Slaves to the bond markets

Australian Financial Review

25 Jul, 1994

In recent weeks, economic policy makers have been centrally concerned with pressure from 'the markets' to raise official interest rates. The result would be to reduce the rate of economic growth which is seen by 'the markets' as excessive and potentially inflationary. But who (or what) are the markets and what do they want?

For most people, the phrase 'the markets' conjures up two, apparently contradictory pictures. The first is of yuppies in their twenties, yelling into their mobile phones as obscure codes signifying vast amounts of money flash past on their computer screens. The second is of inexorable and impersonal forces which have determined that our days as a lucky country are over and which will now force us to conform to the dictates of economic rationalism.

Both of this pictures have an element of truth to them. Financial markets are dominated by speculative traders with a very short time horizon. However, the worldwide reach of the markets, and the fact that the ultimate financing of market transactions is derived from the world's biggest financial institutions, means that it is foolish to attribute any great power to any group of individuals, such as Australian bond traders. Moreover, despite the speculative nature of the market, there is an underlying logic that cannot be disregarded. This logic is consistent in its own terms, whether or not it is conducive to the benefit of ordinary Australians.

The contracts that are traded in financial markets typically consist of promises to pay a certain amount in a stated currency at some future time. For example, the ten-year bond contract, the focus of attention in recent weeks, involves a promise to make a stream of interest payments (in Australian dollars) over a period of ten years and to repay the principal sum (also in Australian dollars) at the end of that period, in 2004. The value of that contract depends on only two things - the future buying power of the Australian dollar and the likelihood that the person making the promise will in fact carry it out. The Australian government can always fulfil its promises to repay by the simple expedient of printing more dollars, so that, for government bonds, the only relevant consideration is future buying power.

What this means is that bond markets are concerned about inflation and only about inflation. It does not matter whether economic growth is strong, weak or nonexistent, whether Australian living standards rise or fall, whether we have full employment or unemployment rates of twenty per cent. If the rate of inflation is four per cent instead of two per cent, the price of bonds will fall (and, correspondingly, the rate of interest will rise).

So, when it is said that the fact that long-term interest rates are two per cent lower in New Zealand than in Australia constitutes a vote of confidence in that country's economic management, it is important to understand precisely what this means. It means that, on average, financial market participants expect inflation to be about two per cent lower in New Zealand than in Australia (because of tax considerations the implied gap is actually closer to 1.5 per cent). Since the New Zealand authorities have recently announced a target rate of 1.5 per cent while most Australian projections suggest a return to rates around 3 per cent, the implication is that both countries are about equally likely to achieve their target rates. The question of whether the ideal rate of inflation, from the viewpoint of economic management, is 3 per cent, 1.5 per cent or even zero is a complicated one. The relevant point here is that financial markets do not care about economic management - they only care about relative rates of inflation.

Even within this narrow conception of economic performance, financial markets are not infallible. The fact that market participants have a great deal of money riding on the outcome means that they are unlikely to let national sentiment or concerns with appearances get in the way of their assessment of the likely outcomes, as politicians and even central bankers frequently do. But this does not mean that they will get things right. All the hardheadedness in the world is of little avail if it is based on a mistaken economic model.

What this means is that it does not matter whether a particular policy is actually conducive to low rates of inflation or not. What matters is that financial market participants should believe that the policy is conducive to low rates of inflation. For example, there is very little evidence relating inflation to taxation systems or to the absolute size of the government sector. However, since the majority of financial market participants are upper income earners employed in the private sector, it is scarcely surprising that they usually regard progressive taxation systems and large public sectors as signs of unsound fiscal policy and imminent inflation.

Furthermore, in the short term, it is more profitable to be wrong with the majority than right with the minority. As a result, most financial market participants, and particularly the 'screen jockeys' engaged in day-to-day trading, spend more time finding out what other participants expect to happen than they do anlaysing the economic 'fundamentals'. This fact can give rise to self-sustaining market 'bubbles'.

Financial deregulation has given the markets immense power, and the rhetoric of deregulation has suggested that they are infallible guides to policy. In fact, financial markets represent the beliefs of a particular interest group, with objectives and ideas very different from those of the Australian population as a whole. As with other powerful interest groups, the financial markets should neither be disregarded nor allowed absolute power. Mnay governments have fallen into trouble by ignoring the kinds of concerns represented in financial markets. At present, however, the main danger is that of slavish obedience.

John Quiggin is Professor of Economics at James Cook University and author of Great Expectations: Microeconomic reform and Australia, published by Allen & Unwin.

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