Is the Bond Market Psychic or Stupid?

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President Obama's proposed commission to solve the long term debt crisis has been met with disdain across the political spectrum. But some commenters -- mostly liberal economists --  think we don't have a crisis in the first place. After all, they point out, look at the bond market. Short term interest rates are near zero and the 10-year yield is in the mid-3 percents, which is awfully low. The bond market doesn't see a fiscal crisis, so why prepare for pain?

Paul Krugman has been making this point for a while. Here he is in August 2009:


Right now GDP is around $14 trillion. If economic growth averages 2.5% a year, which has been the norm, and inflation is 2% a year, which is the target (and which the bond market seems to believe)

And again in November 2009:

Right now, however, the bond market seems notably unworried by deficits. Long-term interest rates are low; inflation expectations are contained (too well contained, actually, since higher expected inflation would be helpful). No problem, right?

Krugman could be absolutely right. But it's a little against character to watch him put this much trust in a market -- a fraught market at that, since acute uncertainty surrounding global markets has created a flight to safety in US dollars that will turn when the world economy recovers. But the deeper problem with deficit-defenders thinking the bond markets are so smart is that the administration running up the deficit seems to think the bond markets are a little bit dumb. So dumb, in fact, that they can be fooled into a false sense of security by a non-security discretionary spending freeze that was righteously mocked by ... everybody. Here's Noam Scheiber on the administration's thinking behind the freeze:

...Given the difficulty of doing anything about the long-term deficit next year, the administration needs some signal to U.S. bondholders that it takes the deficit seriously. Just not so seriously that it undercuts the extra stimulus.

The Orszag approach [writing a budget that's tough on discretionary spending] just might accomplish that. Given the amount of domestic discretionary spending in the federal budget--about $700 billion this fiscal year--we're talking about cuts of, at most, several tens of billions of dollars if Orszag holds the line on spending (and probably less once Congress weighs in). Which means the cuts wouldn't come close to offsetting the likely stimulus. But they just might buy some credibility in the bond market, which could defer the day when the real deficit cutting has to start.

This is about more than what the bond markets are saying. It's about how what they're saying now should guide policy making. Either the bond market is very wise and should act as a lighthouse for our long-term fiscal plans, or it's so hilariously gullible that it will swallow a measure that was mocked by every policy writer with a keyboard and an internet connection. If bond markets can tell the future, they can't be tricked with gimmicks. If they can be tricked with gimmicks, we shouldn't trust them to tell the future. So who is right?

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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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