How Bond Market Vigilantes Force Rates Higher

by Edward Harrison, Credit Writedowns

I see that Paul Krugman has shifted his rhetoric in a recent post on British government economic policy. Let me explain how in this post so that I can make a point as to how bond market vigilantes actually work.

In his post, Krugman points out is that the British government still wrongly believes in the confidence fairy myth that front-loaded austerity can be expansionary because it causes interest rates to go down. But of course, this is nonsense as I have been saying all along. This confidence fairy thing is not new, of course. During the Great Depression, Herbert Hoover believed it too – to devastating effect. And so, now we have George Osborne making the same mistakes. Krugman points out the problem with this way of thinking about interest rates for sovereign currency issuers:

My question, which I’ve raised before, is this: even if you believe that markets would be unnerved by some relaxation of short-term fiscal austerity – which they shouldn’t be, because a percentage point or two of GDP now has virtually no relevance to the long-run budget outlook – how is this spike in long-term rates supposed to happen?

Remember, Britain has its own currency, which means that it can’t run out of cash. Furthermore, the short-term interest rate is set by the Bank of England. And the long-term rate, to a first approximation, is a weighted average of expected future short-term rates. Unless markets believe that Britain is going to default – which it isn’t, and they won’t – this is more or less an arbitrage condition that ties down the long run rate no matter what happens to confidence. Or to be a bit more precise, it’s hard to see what would drive up long rates except a belief that the BoE will raise short rates; and why would it do that unless it sees economic recovery in prospect?

For readers of Credit Writedowns, this explanation should sound familiar. As I noted explicitly in March, the Fed exerts a dominant influence across the yield curve, not just on the short end. You are not going to get rates to rise unless the Fed raises them or inflation and interest rates expectations become unanchored.

And this is exactly how bond vigilantes work in a sovereign currency area. The implicit understanding is that inflation spirals out of control and the bond vigilantes front run the central bank’s move to counteract this inflation. A lot of people act like the bond market vigilantes are in control here. That’s not the case. The bond market vigilantes are not forcing the central bank’s hand. The central bank controls the policy rate and can continue to keep that rate at which ever level it chooses. Now, I am not a fan of this particular piece of central planning, to be honest with you. But that’s how it works. The central bank is essentially a central planner. It determines what level short-term interest rates are and the market must accept this if banks want to transact in reserves that only the central bank controls.

The question, therefore, is whether inflation can ever rise enough to force the central bank into action. And any increase in longer-term yields is an implicit indication that bond market participants believe it could.

It is good to see Krugman acknowledge this so directly because just two years ago, he made a point of putting it the wrong way around, stressing the fact that out of control deficits would force inflation higher after the US left its temporary and rare “liquidity trap“.

For example, Krugman wrote:

Suppose, now, that we were to find ourselves back in that situation 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?

[…]

…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.

OK.

Here’s the thing though. This is a straw man argument.

Why would government run trillion dollar deficits if we weren’t in a depression? Deficits are ALREADY shrinking dramatically. Krugman acts as if the deficit is a fully exogenous variable decided by political fiat. It isn’t.

The deficit is mostly endogenous, meaning the deficit is the result of the aggregate savings propensity of the private sector. If people are no longer deleveraging i.e. increasing private savings, why would public deficits be large?

They wouldn’t – and Krugman should know this. It’s the sectoral balances, folks.

How about this follow-up clarification post from Krugman:

A followup on my printing press post: I think one way to clarify my difference with, say, Jamie Galbraith is this: imagine that at some future date, say in 2017, we’re more or less at full employment and have a federal deficit equal to 6 percent of GDP. Does it matter whether the United States can still sell bonds on international markets?

As I understand the MMT position, it is that the only thing we need to consider is whether the deficit creates excess demand to such an extent to be inflationary. The perceived future solvency of the government is not an issue.

I disagree. A 6 percent deficit would, under normal conditions, be very expansionary; but it could be offset with tight monetary policy, so that it need not be inflationary. But if the U.S. government has lost access to the bond market, the Fed can’t pursue a tight-money policy – on the contrary, it has to increase the monetary base fast enough to finance the revenue hole. And so a deficit that would be manageable with capital-market access becomes disastrous without.

Now, my understanding here is that Jamie Galbraith is not an MMT guy. Instead, like me he uses similar analytical tools – like the sectoral balances approach that Jan Hatzius uses to great effect, for example. So I just want to make that point because it seems to me that Krugman’s straw-manning in 2011 was just an attempt to create rhetorical space between himself and other economists he believes are not sufficiently credible within the body of mainstream economists. The reality is that had Krugman used the sectoral balances approach here, he never would have positioned his argument the way he did in 2011.

In truth, outside of the sectoral balances approach, Krugman’s argument is the same as Galbraith’s and mine – and the same as the MMT folks as well. The difference is he straw-manned the deficit as an exogenous policy variable in 2011 when it simply isn’t one. On the substance, again, this is the same bogus argument as in the previous post.

Of course running enormous deficits when the economy is operating at full capacity causes inflation to go haywire. Of course it does.

But again, why would the government have a large net deficit position if the private sector is not deleveraging and running up its net saving position? This could only happen if our politicians went mad and added yet more fiscal stimulus to the economy even after it was overheating.

Luckily, Krugman has changed his approach significantly. And with the UK post, he stresses different arguments.

Bottom line: the deficit is mostly an endogenous variable – the result of how existing fiscal policy interacts with private sector savings and consumption decisions. In economic parlance, the deficit is the result of an ex-post accounting identity, not an ex-ante economic variable to target for economic policy. The deficit automatically increases during an economic crisis, as it did after 2009 everywhere in the industrialized world. The deficit also automatically declines when private net savings declines, as it does when an economy recovers from a private sector debt crisis. That’s what’s happening now. In today’s circumstances, it is completely unrealistic to expect high levels of inflation that would force the central bank to raise policy rates. Right now, inflation and inflation expectations are actually decreasing, not just in the US but globally.

Wait until inflation starts to creep up. Then the bond vigilantes can get going. But this is a long way off.