DeLong Smackdown Watch: Paul Krugman vs. Invisible Bond Vigilantes Weblogging Edition
Paul Krugman:
Bond Vigilantes and the Power of Three: The popular story about how an attack by bond vigilantes can cause an interest rate spike and turn America into Greece… is incoherent…. Think of a simplified world in which there are three kinds of assets: short-term securities, long-term government bonds, and foreign assets…. Individual investors can shuffle their portfolios…. [T]here are three prices… short-term interest rates, long-term interest rates, and the exchange rate. At any given time, however, one of these is fixed, leaving it up to the other two to do the adjusting. Which two? That depends on the monetary regime….
The United States has independent monetary policy and a floating exchange rate. The Fed uses its independence to set the short-term interest rate… long-term rates and the exchange rate do the adjusting…. If you think short-term rates are heading up [because the Fed thinks the depression is about to end]… long-term bonds become less attractive; better to park your money and wait for better yields…. In such a case long-term rates rise--but because this rise is driven by greater optimism about the future, it's hard to see how it can have a contractionary effect on the economy.
Incidentally, this seems to me to be a big problem with the story Brad DeLong tells about bond vigilantes in the very early 1990s. He argues that the wide gap between short-term and long-term rates reflected market expectations that deficits would eventually cause higher inflation…. But why would such expectations be a drag on the economy? Yes, nominal rates would be higher than otherwise; but real rates would, if anything, be lower. It's not at all easy to tell a coherent story in which the effect of future expected deficits on today's interest rates is contractionary….
[T]he big fear now is that we'll have a quite different type of vigilante attack, in which fear of default leads to a general flight from our nation's assets, sort of like this…. Well, if you're Greece, the exchange rate is fixed…. So what happens is that both short-term and long-term interest rates rise… funds flee the country [and] the money supply plunges…. But that can't happen in the United States, where the Fed retains control over the money supply and of short-term interest rates. So what would happen instead would be a plunge in the exchange rate. And this would actually have an expansionary effect on the U.S. economy.
The point is that the analogy with Greece is just completely wrong; the difference in our monetary positions means that even if the bond vigilantes did attack, they would probably help, not hurt, our economy in the short run.
Three points in response:
First, if Tim Geithner--or somebody else who believed that a strong dollar is always and everywhere in America's interest--were in charge of the Federal Reserve when the bond vigilantes appeared and began selling long-term bonds for foreign assets, he could turn the United States into Greece if he decided to react by pegging the value of the dollar. The Federal Reserve would then respond to the fall in the dollar and the rise in long-term interest rates by raising short-term interest rates to pull hot money back into the United States. That increase would pull the dollar back up. It would also push long-term interest rates up even further--which could then cause momentum traders to try to get ahead of the curve by selling even more long-term domestic bonds for foreign assets, which would push the dollar down and call for another round of increases in short-term interest rates to maintain the strong dollar that is in America's interest--and then we would be Greece.
Second, if the major New York banks have placed large leveraged bets on the continuation of the strong dollar policy by selling unhedged dollar puts, then the U.S. is Greece, and is vulnerable. Do the major New York banks understand their derivative positions? Does the Federal Reserve understand the derivative positions of major New York banks? Are they properly regulated and surveilled? The questions answer themselves.
Third, back in 1992-94 the level of short-term interest rates was not an increasing monotonic function of the rationally-expected future state of the economy. If it were, Paul would be correct: the bond-market vigilantes would attack only when the economy strengthened, and their attack could moderate and partly offset growing economic strength but not produce economic weakness.
But there were--and are--other motives that could trigger an attack by bond-market vigilantes. One would be a rationally-expected belief that the Federal Reserve is about to start raising short-term interest rates even though the economy is weak because it fears an outburst of inflation. Why should the Federal Reserve fear such an outburst? It would if it believed that inflation might accelerate because the national debt is high even though unemployment is still far above the NAIRU. Could the Federal Reserve believe such a silly and counterintuitive and irrational thing? Alan Greenspan is the type of person who is named to chair the Fed. The question answers itself. For Paul Krugman's argument to be water-tight it is not enough for it to be irrational for the Fed to inordinately fear inflation and raise short-term interest rates when the economy is depressed, it must be the case that the Fed will not inordinately fear inflation and will not raise interest rates when the economy is depressed.
