Fiscal Ratios As Well As Bond Yields (Again)

More give-and-take on the blogosphere almost financial risks. Nick Rowe responds to others' (Paul Krugman, Simon Wren-Lewis) posts almost Ken Rogoff's financial fears (see Nick Rowe's article for the links to the other posts).  

This utilisation from Rowe's article struck me:

 In the normal equilibrium, the quantity of regime bonds demanded depends on normal things similar the existent involvement charge per unit of measurement on those bonds as well as the expected probability of default (whether through unforeseen inflation or through uncomplicated non-payment of obligations). So inward the normal equilibrium, a higher stock of debt, other things equal, agency a higher equilibrium involvement charge per unit of measurement on that debt. And a higher involvement charge per unit of measurement implies a higher mind surplus needed to service that debt as well as forestall the debt/GDP ratio rising. And running a mind surplus is something governments don't similar to do, as well as and thence the higher the mind surplus the higher the run a jeopardy of default. And the higher the run a jeopardy of default, the higher the charge per unit of measurement of involvement would bespeak to endure to persuade people to concur the debt. Which creates a positive feedback loop, because it agency a higher mind surplus...which mightiness practise a crisis, if the positive feedback effect is potent enough.

[UPDATE: Upon re-reading what I wrote here, I realise that I should accept noted that the text inward a higher house is non necessarily what Nick Rowe believes; he is constructing a possible explanation for the being of financial risks.  And my comments hither are deliberately missing a lot of his declaration inward guild to hand a curt response. Think of this equally a quick summary of a longer critique.]

I volition repeat what I've written elsewhere: if you lot build into your model the supposition that investors demand an increasing run a jeopardy premium equally debt ratios rise, at that spot is a run a jeopardy that debt "spirals out of control" inside the model. But that is only an obvious effect of your assumption; to utilisation a fancier word, it's a tautology. But if you lot assume that bond markets are efficient (no run a jeopardy premium based on financial ratios, since default does non be inward the context of the model), this effect disappears.

There is no way of deciding which supposition is right without looking at the data: the dissimilar assumptions should generate dissimilar predicted behaviour. I volition betoken to 2 observed effects:

• Observed (nominal) bond yields drib equally debt-to-GDP ratios rise. Yes, this outcome is somewhat flimsy for a seat out of reasons, but it does heighten the bar for the belief inward financial run a jeopardy premia.
• It is real hard to explicate electrical flow JGB yields, or fifty-fifty Treasury yields if the financial run a jeopardy premium is anything to a greater extent than than 20-30 dry ground points. This is besides minor to measure, as well as is besides minor to generate the feedback loop described above.

(c) Brian Romanchuk 2013