At this point, inflationary expectations will increase, long term government bond yields will rise, and the recovery will be crowded out.

Long term government bond yields are already very low, and a further reduction will not significantly change private agents borrowing costs.

While that could be contractionary, the gain in fiscal policy credibility might prevent a damaging spike in long term government bond yields.

Global stock markets have, overall, reached new highs. And credit markets show low spreads, while long term bond yields have fallen in most advanced economies.

Long term inflation indexed bond yields have fallen to around 1 a year, or less, in the United States, Canada, the United Kingdom, and the eurozone.

When that happens, inflationary expectations will mount, long term government bond yields will rise, mortgage rates and private market rates will increase, and one would end up with stagflation (inflation and recession).

But the immediate effect on long term bond rates has not been encouraging.

Eventually, large monetized fiscal deficits will lead to a fiscal train wreck and or a rise in inflation expectations that could sharply increase long term government bond yields and crowd out a tentative and so far fragile economic recovery.

The gaps between German bond yields and Italian and Greek yields are at record levels. The price of default insurance has tripled.

Bond market vigilantes already have taken aim at Greece, Spain, Portugal, the United Kingdom, Ireland, and Iceland, pushing government bond yields higher.

Frustrated investors would then dump their US Treasury securities. Bond yields would shoot up.

Otherwise, Treasury bond yields would be far higher, thwarting monetary expansion by the Fed.

But if monetized fiscal deficits are allowed to run, the increase in long term yields will put a chokehold on growth.

The low interest rate on long term Treasury bonds has also boosted demand for other long term assets that promise higher yields, including equities, farm land, high yield corporate bonds, gold, and real estate.

The bond channel doesn t work when bond yields are already low and the credit channel doesn t work when banks hoard liquidity and velocity collapses.

Local currency bond markets could help to develop domestic investor bases and mobilize domestic savings to support long term investments.

38 For example, through strengthening institutions that provide long term finance, such as development banks and, where appropriate, bond markets.

The greatest risk to bond holders is that inflation will rise again, pushing up the interest rate on long term bonds.

Clearly, the Fed s objective is to increase bond prices, in the hope that lower long term interest rates will propel corporate investment.

So what will happen when central banks start raising interest rates? In 1994, rising short term rates caused increases in long term rates and declines in long term bond prices that were at least double what standard models at the time were predicting.

Bond yields in southern Europe were rising, and a pervasive sense of apprehension and fear cloaked governments in European capitals.

Third, Germany s long term interest rates would be unaffected, because Germany would neither be guaranteeing the debt conversion scheme nor backing the ECB s bond issues.

The low interest rate on long term Treasury bonds has also boosted demand for other long term assets that promise higher yields, including equities, farm land, high yield corporate bonds, gold, and real estate. When interest rates rise, the prices of those assets will fall as well.

Meanwhile, rising fiscal deficits in most economies are now pushing up the yields of long term government bonds. Some of the rise in long rates is a necessary correction, as investors are now pricing a global recovery.

In November 2004, the European Investment Bank (EIB), working with the private bank BNP Paribas, announced that it would issue the world s first long term longevity bond.

Over the longer term, increased food yields could be turned into sustained economic growth.

Investors subsequent efforts to price in the risk of a eurozone breakup not the volume of sovereign debt caused bond yields to spike.

The resulting uncertainty could trigger more volatility, especially in bond markets, potentially impeding economic recovery (for example, by pushing up long term mortgage rates) or augmenting future inflation risk.

Short Term Talk, Long Term Cost

Buying time for reform to work requires socialization of short term risk. There is no other way to keep bond yields under control and banks functioning, and there is no ironclad guarantee that the reform programs needed to do the job will be approved.

The current 30 year T bill yields 3.2 annually, which means that, unless the marginal bond buyer today is unusually averse to holding 30 year Treasuries, she anticipates that short term nominal T bill rates will average 1 per year over the next generation.

Long term Recommendations

Medium term fiscal reform, for its part, will be pushed by bond market vigilantes.

Likewise, an IMF program for Ireland which seems increasingly likely will not bring down domestic bond yields and reopen credit markets to any kind of Irish borrower.

While Draghi s promise, embodied by the ECB s outright monetary transactions program as well as its long term refinancing operation and emergency liquidity assistance program has bought time and lowered yields, the eurozone s banking crisis persists.

(r) Long term contracts

Long term stockholders alone do not encourage a firm s managers to manage for the long term.

They fail to build long term markets and long term opportunities, the crux of business success.

Most importantly, they have to be long term, since reconstruction itself is a long term process.

Europe, gripped by a tremendous banking and debt crisis, is not an attractive destination, and loose monetary policy in the US has produced ultra low bond yields there.

Euro accession and bull market convergence trades pushed bond yields in these countries toward the level of German bunds, with the ensuing credit boom supporting excessive consumption growth.

If the Republicans threats were credible, any news that increased the likelihood of a problem with the debt ceiling would send Treasury bond prices down and yields up.

The policy has short term and long term objectives.

So the long term could be long in coming.

The problem is that such long term investments bring results only in the medium and long term.