Tuesday, November 13, 2012

What if the bond vigilantes attack the US?

One of the cryptic scenarios inflation scare-mongers and deficit hawks like to throw around is an attack of the bond vigilantes. Paul Krugman looks at this scenario in The Simple Analytics of Invisible Bond Vigilantes Nov 2012, a paper which is warns is wonkish. But the conclusion is clear:

Think about it this way: with the Fed setting interest rates, any loss of confidence in U.S. 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.

You can elaborate on all this, in particular by making a distinction between long-term and short-term interest rates. But it’s really hard to create a scenario in which the bond vigilantes actually cause a contraction rather than an expansion when they attack. Things will be different if you have large debt denominated in foreign currency – but we don’t.

So what are the fiscal fear types thinking? Basically, they aren’t. But to the extent that they do have a model, ... – they’re imagining that American macroeconomics are just like those of a country on a fixed exchange rate with no independent monetary policy.
He elaborates on it in a couple of blog posts. In When Confidence Hurts 11/12/2012, he talks about how his analysis fits other financial crisis of the last few decades:

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.

Oh, and one more thing: there are cases right now of countries with their own currency but with lots of foreign-currency debt that make depreciation contractionary versus expansionary — for example, Hungary (where lots of people took out mortgages in Swiss francs!) So this is still a relevant distinction.
In More on Invisible Bond Vigilantes 11/10/2012, he cites this 10/18/2012 letter under the letterhead of the Financial Services Forum signed by various CEOs, including whinin' Jamie Dimon of JPMorgan Chase and Brian Moynihan of Bank of America, using fiscal cliff scaremongering to indulge in (code-worded) lobbying for the Grand Bargain to cut benefits on Social Security, Medicare and Medicaid. Krugman's response:

The letter is actually kind of amazing in a bad way even before we get to that issue: the CEOs apparently can’t or won’t get their heads around the fact that the fiscal cliff issue is all about doing too much, not too little, to reduce the deficit. Somehow, by the fourth paragraph concerns about a rise in taxes and a fall in spending depressing demand have turned into bond-vigilante fearmongering, with a warning that Moody’s might downgrade US bonds and send interest rates up. Guys, that’s not what we’re talking about here.

But even if we accept the bait-and-switch, from fiscal cliffery to fear of what will happen if we don’t have a Grand Bargain now now now; and even if we ignore the likely market reaction to a Moody’s downgrade, which would probably be a collective yawn (remember that absolutely nothing happened when S&P weighed in); the logic is still wrong. Even if Moody’s succeeded in scaring people, this would mean a weaker dollar rather than soaring rates — and this would be good, not bad, for the US economy.

It’s scary to think that such muddled thinking has dominated "serious" discussion.
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