Paul Krugman: The Simple Analytics of Invisible Bond Vigilantes (Wonkish)


The Simple Analytics of Invisible Bond Vigilantes (Wonkish), by Paul Krugman, in NY Times: I’ve been in several conversations over the past few days with generally reasonable people who are still worried that markets might turn on U.S. bonds any day now. I don’t think they’re right; but even if they are, I’m not clear what they believe would happen next. For the fact is that it’s much harder than most people seem to imagine to tell a Greece-type story about a country with its own currency and a floating exchange rate.

And since I was stuck on an airplane, I thought I might write up a very simple, old-fashioned model (pdf) making that point.

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More on Invisible Bond Vigilantes, by Paul Krugman, in NY Times: I argued yesterday that even if the heretofore invisible bond vigilantes materialize one of these days, their attack won’t have the effects the deficit hawks imagine. Because America has its own currency and a floating exchange rate, a loss of confidence would lead not to a contractionary rise in interest rates but to an expansionary fall in the dollar.

Here’s a case in point of people getting this wrong: the letter by 15 financial CEOs (pdf) urging a quick resolution of the fiscal cliff.

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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