Ever since the federal government and Federal Reserve’s unprecedented responses to the financial crisis, hard-money types such as Peter Schiff (and less famously, me) have warned Americans to prepare for sharply rising price inflation and interest rates. Keynesians such as Paul Krugman dismissed such fears with the term “invisible bond vigilantes,” and understandably have been pointing to the record-low yields on Treasury securities as proof that the “inflationistas” (another derogatory term) are crazy.
Thus far the debate had been at a standstill: The hard-money types could claim that the dollar and Treasuries were in unsustainable “bubbles,” just as the housing market had been. Peter Schiff was famously laughed at by the pundits in 2006 for warning of a coming crash, and only time will tell if he has also been right about the stimulus package and various rounds of quantitative easing.
However, in a November 9 blog post Paul Krugman took matters even further. He argued that even if the hard-money types were correct, and investors around the world suddenly doubted the ability of the US government to repay its debts…that this would help the US economy. In a moment I’ll walk through Krugman’s extended argument (he dubs it “wonkish”) and show where he goes wrong in reaching such an absurd conclusion. But to reassure the reader that this really is what Krugman is saying, let me quote from a post three days later, in which Krugman responds to a correspondent who (understandably) couldn’t believe the Nobel laureate actually meant what he had written:
A skeptical correspondent asks whether I really truly believe what I’m saying in my post about how an attack by the bond vigilantes is actually expansionary when you have your own floating currency. How does this jibe with the experience of the Asian financial crisis of the 1980s, he asks? And do I really believe that Japan would be better off if markets became less confident in the value of its bonds?
Good questions — but ones that I and others have already answered.
On financial crises past: the key question is whether you have large debt denominated in foreign currency…
The point, of course, is that America doesn’t have a lot of foreign-currency debt. Neither does Japan — which is why I would say yes, reduced confidence in Japanese bonds would actually help their economy. Right now, as I’ve written in the past, the collision of deflation with the zero lower bound means that Japan actually offers investors a higher real interest rate than they can get in other advanced countries. The result is a strong yen that is really hurting Japanese manufacturing. Some loss of faith in those Japanese bonds, whether default risk or fear of higher inflation, would be a blessing. [Bold added.]
So we see that I’m not setting up a straw man here—Krugman is saying (a) right-wingers are nuts for worrying that worldwide investors will lose faith in the dollar/Treasury bonds, since that isn’t going to happen, but (b) right-wingers are doubly nuts because even if it did happen, this loss of faith in dollar-denominated assets would be a good thing for the American economy.
In the “wonkish” link from his blog post, Krugman explains the backdrop for the simple model he is about to create:
We know what a loss of faith in Greek bonds looked like: interest rates soared, with negative consequences for the Greek economy. But Greece didn’t have its own currency, and therefore didn’t have its own monetary policy or its own exchange rate. We do. So what would an attack by invisible bond vigilantes look like for the United States… ?
Krugman then runs through a derivation of his final equation, showing how the interest rate (set by the Fed) can influence domestic demand and also net exports. We don’t need to run through the math, because Krugman conveniently spells out how the rabbit got into the hat:
[W]hat happens if there’s a loss of confidence, causing the risk premium [on US government debt] to rise? The answer is that the currency depreciates for any given domestic interest rate, increasing demand…That is, the effect on the economy is expansionary.
Think about is this way: with the Fed setting interest rates, any loss of confidence in US bonds would cause not a rise in rates but a fall in the dollar—and a fall in the dollar would be a good thing, helping make US industry more competitive.
And there you have it: The reason a sudden loss of investor confidence in government debt was earth-shattering for Greece, but would (allegedly) be good for the US, is that Greece didn’t have recourse to a printing press. Therefore its nominal interest rates went way up, because the ECB refused to soak up an unlimited amount of Greek debt on its balance sheet.
In contrast, Krugman claims that the Fed always has the power to keep interest rates on Treasury debt whatever Bernanke wants them to be. This is because there are no constraints on the Fed from creating more dollars out of thin air, and using them to buy Uncle Sam’s debt, until the yields on that debt hit their target value.
Now the interesting thing about Krugman’s wonkish, 6-page exposition is that he doesn’t qualify it at all. He doesn’t say, “This all assumes we’re in a liquidity trap.” In fact, at the beginning he makes an open-ended statement that even though investors don’t currently worry about a US government default on its bonds, “it is indeed conceivable that international investors at some point might become less sanguine about US debt.”
Such a broad application of Krugman’s result is clearly wrong. To say that a country with its own currency can just print money and keep nominal interest rates at whatever it likes, is to ignore the elephant of the room that a depreciating currency is a euphemism for rising domestic prices, i.e. what most people mean by “inflation.” Thus the problem of spiking interest rates is simply “solved” by giving Americans spiking prices.
This isn’t even an “Austrian” point; I can find a Keynesian blogger who made the point quite nicely last year:
So suppose that we eventually go back to a situation in which interest rates are positive….with the government still running deficits of more than $1 trillion a year, say around $100 billion a month. And now suppose that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates.
So then what? The Fed could directly finance the government by buying debt, or it could launder the process by having banks buy debt and then sell that debt via open-market operations; either way, the government would in effect be financing itself through creation of base money. So? …
Does this mean 400 percent inflation? No, it means more — because people would find ways to avoid holding green pieces of paper, raising prices still further.
I could go on, but you get the point: once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation…
At this point I have to say that I DON’T EXPECT THIS TO HAPPEN — America is a very long way from losing access to bond markets, and in any case we’re still in liquidity trap territory and likely to stay there for a while. But the idea that deficits can never matter, that our possession of an independent national currency makes the whole issue go away, is something I just don’t understand.
The blogger who wrote the above was Paul Krugman.
In closing, let me plug one last hole: Krugman would no doubt defend his two posts by saying that we are currently in a liquidity trap, and that even though he didn’t mention the caveat in his “wonkish” discussion, it should have been assumed he meant a strike by bond investors would only be helpful in that case. Once we’re out of the liquidity trap, then sanity returns to the world, and right-wingers are indeed justified in saying it would hurt for the Treasury market to crash.
Yet hang on a second: Krugman defines a liquidity trap as a situation where the Fed has pushed interest rates down to zero, without fixing the economy. So what Krugman is saying is that if investors suddenly stopped wanting to buy US bonds, but the yield on them remained at 0 percent, then this would be a good thing. However, once interest rates became positive again, then the bond strike could lead to hyperinflation.
With that clarification, somehow I don’t feel reassured.