Here is this week’s Scotonomics, we hope you will enjoy. This week the newsletter comes from William Thomson (follow me on X/Twitter!)
How would we even attempt to sum up the past month since our last newsletter?
The tariff debacle in the USA and the upending of 40 years of consensus. The spring statement with that £5 billion that “must” be cut from the UK benefit bill. The potential of the UK Government nationalising British Steel and continuing to talk about doing the same for Thames Water. But nothing for Scotland’s only oil refinery at Grangemouth.
In Europe the normally frugal Germans have voted to abandon their debt brake and speed into the fast lane with a massive €500 billion allocated to defence spending and another €100bn for investment, including climate investment (around €8bn a year – so no one is getting carried away). I get the feeling that most months are going to be like this.
It is useful to have a guiding star when trying to make sense of economics. Being a political economist really helps. This enables me to look at where the power really lies. Understanding that the government – as a currency issuer – holds the key economic power of public money creation is essential. In other words, monetary sovereignty is a real thing. So if tariffs or tax cuts create issues in the bond markets, the central bank has the power and the duty to calm those markets. It is a political choice for the Labour Government to cut benefits. And when Germany (or any similar nation) wants to find €600bn it can do it. Finding the money is never the problem.
This week the mainstream narrative was that tariffs had spooked the bond market and the government had to back down. So is it true that the great nation of the USofA is not a monetary sovereign?
Trump’s national lottery
I like to picture Trump et al. in front of one of those machines they used to use for the National Lottery. “The tariff this week will be … 10%, followed by 25%, 30%, 35% and 40%. And the bonus ball this week is 145%”. It would be hard to argue that this would be any less scientific than what is going on.
Earlier this week Robert Peston said on an extended thread on X he wrote that “Donald Trump, has a boss: The bond market”. This was in response to Trump dialling back on tariffs at the same time as some owners of American debt started to sell more than usual. So if the Government isn’t in charge, who is?
Bowing to private sector power
The mainstream loves the idea that markets are in charge, not elected politicians. Modern Monetary Theory (MMT) rejects this idea completely. And here is the evidence.
The interest you get on a bond (the yield) moves in the opposite direction to bond prices. When institutions start selling bonds yields start to rise and the mainstream gets in a right frenzy. This week, the interest you earn on a 10-year US bond went up 0.5%. To the mainstream this meant Trump was being tasked by bond vigilantes.
Here is the yield on 10-year US bonds for the last two years. You can see the most recent spike for example is well below the rate in January. Also note that throughout this period the yield sat between 3.25% – 5%. This was close to the overnight interest rate offered by the Fed. There is no evidence that the bond market is dictating this rate. Those in the market are price takers.
Basically, the 10-year rate is a function of the rate being paid on new debt with a chunk of expectations of the future rate and a risk premium. Peston’s long thread was not news. He wasted the privilege of having a blue tick on X and wrote a few hundred unnecessary words. Unfortunately the headline “yield on bonds very much unchanged in two years despite Trump’s tariffs” is not a very interesting story. But that is the story.
But let’s say the yields did continue to rise. All that would need to happen was for the Fed (a government agency) to start to buy enough bonds to get the yield back close to the overnight rate. If people see the price of bonds going back up they become more popular again. We know that the Fed would intervene because this is what happens all the time.
The Fed, the Bank of England, and every other central bank, buys and sells bonds to keep the yield curve at a target rate. This week Susan Collins, president of the Boston Fed speaking to the FT said: “We would absolutely be prepared to do that [use various market interventions] as needed.“ The Boston Fed is simply stating the role of a central bank and this is why the graph above closely matches the overnight rate set by the Fed.
The misunderstanding of the monetary system runs deep in the mainstream. The BBC states that bonds pay for spending in the USA and that selling off debt will limit the government ability to finance itself. The Independent said the Fed “threatens to step in”. This is like saying doctors threaten to step in to cure a patient. It is nonsensical.
Did Truss show that the UK is not a monetary sovereign?
Yields rose after Truss’s mad mini budget. Did the bond market win?
You can see the 0.5% increase after the budget in September 2022 when all hell broke loose! But look what happened shortly after. The rate fell back down to where it was three months before. And even more interestingly, the rate that shunted Truss out of the door is lower than it is now.
In fact it was below the average for the last two and a half years! The 10-year rate is always very closely aligned with the Bank of England’s overnight rate. And that is because the Bank of England sets the overnight rate and the bond market responds. Not the other way around. The truth is that the central bank sets the rate paid on newly issued debt and this is the main factor that affects outstanding debt.
The final thing to clear up for readers is the idea that if yields go up the Government has to pay more interest. If the yield for debt already in the market rises or falls this has no impact on the interest the Government pays on newly issued debt. The Government issues debt at the interest rate it sets.
My favourite thought exercise is to consider what would happen if you said to the bond vigilantes: “OK, no more bonds will be sold this year. You will have to find other assets that are 100% safe that you can buy with all the dollars (US) pounds (UK) you have…” Let’s see who is in charge then!
Economist Stephanie Kelton refers to this as “learned helplessness” and unfortunately it is real. All too often elected politicians are unable to see the power they have. But we can’t be too surprised. When you have Peston, Conway on Sky, the Independent and the BBC all shouting at you that the markets are in charge it is natural that they start to believe that they don’t have the power. But look for evidence and take time to understand the institutions and you see that the power lies with the politicians. If only they would use that power for the public purpose.
