Sasha Issinberg: Boo-Boos in Paradise
Liveblogging World War II: November 13, 1942

Bond Market: Vigilantes, or Cavalry?

Paul Krugman: writes:

an attack by bond vigilantes has very different effects on a country with a fixed exchange rate (or a shared currency) versus a country with a floating exchange rate. In the latter case, in fact, loss of confidence is expansionary…

You gain more from the extra exports triggered by the decline in the value of the currency than you lose from depressed interest-sensitive spending--in fact, as long as interest rates stay at their zero lower bound and on their previous path, you lose nothing from depressed interest-sensitive spending from an attack by bond-market vigilantes. It would have to be not just a financial market affair but hit business investment committee confidence at all for there to be any drawback. At least, that is what happens if the exchange rate is floating.

If the central bank pegs the exchange rate--believes, say, that a strong dollar is always and everywhere in America's interest--than we are back to the fixed-exchange rate case.

Nick Rowe raises a caveat:

Worthwhile Canadian Initiative: Waiting for the bond vigilantes: Paul Krugman is right if he is talking about a small attack by the bond vigilantes. It's a good thing, because it increases Aggregate Demand, which is what the US economy needs. But too much of a good thing will be a bad thing. A large attack by the bond vigilantes would be a bad thing, because it would increase Aggregate Demand too much. That would force the Fed to increase interest rates a lot, and that would force the US government to raise taxes and/or cut spending to cover the increased costs of servicing the debt.... [I]f the debt were large, the amount by which taxes would need to be raised and/or spending cut to cover the increased debt service costs would be large too, and it could not easily be done. The longer the US stays in recession, with a large budget deficit, the bigger the debt will grow.

This does not look to me to be a very stable system. And the longer the bond vigilantes wait before attacking, the less stable it looks.... The bond vigilantes will eventually attack and rescue the US and Japanese economies from recession. But every year they wait before attacking, the bigger that attack will be. And they won't attack until they have grown bigger than we would want them to be.

To my mind, this reinforces the urgency for something like NGDP targeting. We don't want to wait for the bond vigilantes.

Nick Rowe speaks sooth.

There is, I think, one thing he misses. Demand for U.S. Treasuries is a function not just of bond market confidence but also of the regulatory structure. The government can regulate to boost the demand for cash and Treasuries: high capital requirements for financial institutions are a very effective way of cooling-off aggregate demand and reducing the burden of servicing the U.S. debt. And capital requirements can, if the government wishes, be made very high indeed...