The bond vigilantes
Who’s afraid of the big bad wolves? It appears that many governments are.
Policy makers around the world seem to be terrified of the “bond vigilantes”. Their stealth appearances drive up interest rates and panic policy makers into enacting drastic measures to reduce their budget deficits.
We have witnessed several onslaughts by these so-called bond vigilantes in Europe, and periodically we hear predictions about their inevitable attack on US Treasury bonds. Indeed, the supporters of gold as the safe haven investment against the ultimate day of reckoning in the US keep emphasizing this eventuality.
Is the world safe from these vigilantes? Should we really care about them? To answer these questions, we must first determine who they are and what drives them.
Fortunately, the answers to these latter two questions are straightforward. The vigilantes consist of the hyperactive traders employed by financial institutions worldwide. Trading is like a narcotic for them, with the pursuit of money secondary – just a means for keeping score and buying toys. They are driven, like addicts, by the need to continuously be trading something. And despite their numbers, they tend to be and act like a small club, but a club of voracious wolves. When someone leads, the rest of the pack jumps in for the kill.
They are not long-term investors in anything, nor do they care about fundamentals. Like gamblers, and this is what they truly are at their core, they lust for the high of the next bet. However, unlike the gamblers in Vegas or Macau, they are relentless and deal in substantially larger wagers. While the gamblers in Vegas and Macau cannot shake the world, the traders can and often do.
Some trading activity does serve a useful role – providing liquidity and creating markets. More and more however, this activity is resembling pure gambling with no useful economic or social purpose. The trading/gambling addiction increasingly destabilizes markets and creates costly price volatility and uncertainty in most markets.
So why do governments tremble when the vigilantes attack? Largely because of fear, ignorance and an unwillingness to stand up to them. In the case of Europe, Germany caved to support the outstanding debt of the PIIGS because significant amounts were held by German banks. Germany feared that if it did not intervene to stop the attacks on the debt of the PIIGS, German banks would face further write-downs in the values of their bond holdings, thus jeopardizing their solvency.
Germany could have opted to prop up its banks instead, signaling to the bond vigilantes that it did not care what they did. Eventually, the vigilantes would have gone away in pursuit of their next prey. But by propping up the PIIGS, Germany offered the vigilantes”no lose” bets. Just attack one of the PIIGS (sell their bonds short), wait for the EU to intervene, and then reverse the bets (buy the bonds).
Some have argued that the vigilantes play an important role in keeping governments honest by compelling them to become fiscally prudent. Governments are not prudent when they cut spending and increase taxes at times of weakness in their economies. Such actions only exacerbate the underlying weakness, and consequently, the unemployed end up paying a very high price to satiate and enrich the vigilantes.
If traders want to gamble, let them – but don’t encourage or subsidize them. The rules should be changed to make this type of behavior more costly and less attractive.
Economic theory is quite clear – activities, which produce negative externalities, and gambling by the traders falls into this category, should be taxed and/or regulated. The Tobin tax should be a starting point. This tax should be buttressed by a tax policy that subjects all gross winnings to the full income tax rates – they should not be taxed at preferential capital gains rates. Furthermore, all gross losses should not be allowed to be written off against any gross winnings or other incomes. If the traders win, let’s make sure we get our fair share in taxes. If they lose, let them eat their losses alone.
The opinions expressed in this blog are personal and do not reflect the view of either Global Brief or the Glendon School of Public and International Affairs.