Paul Krugman does believe that an attack of the bond vigilantes would be expansionary

You can read him here.  Keep in mind we are talking about a sudden leap upward in interest rates, a sharp rise in the risk premium, and a sudden fall in bond prices.  In response, I suggest a multi-step program:

1. Read Gary Gorton on how much the decline in the value of mortgage securities — if only as collateral — damaged the global economy during 2008 by causing a credit collapse, including in but not limited to the shadow banking system.

2. Estimate size of said effect for a serious price decline for U.S. Treasury securities, a much larger and more central and otherwise more secure market.  Do not leave out margin call effects or negative effects on the eurozone.

3. Compare said effect to short-run benefits from exchange rate depreciation, taking into account lags and J-curve effects and the relatively closed nature of the American economy and the slowdowns in other countries around the globe.

4. Run a Chicago Booth questionnaire study to see how much of the profession will agree with you.

5. Flee in panic.

6. Start praising the Republican Party for their macroeconomic acumen in damaging the credit reputation of the U.S. government.

7. Declare yourself an “elasticity optimist” when it comes to relative price shifts and lower tax rates.  Team up with the U.S. Chamber of Commerce to write a study calling for the immediate slashing of corporate tax rates, or at least corporate tax rates as applied to exports.  The theory of exchange rate incidence is the theory of tax rate incidence, and furthermore, by happy coincidence, lower tax rates do not involve all of the costs of a financial crisis.

8. Ponder technical questions such as “if I think bad news is more than offset by gains from exchange rate depreciation, do I also think that good news is more than offset by losses from exchange rate appreciation?”

9. Read Thucydides, or perhaps Broadwell, about how a crisis is not always manageable once underway.

Krugman’s is a reckless position, and simply noting that America borrows in its own currency doesn’t come close to defending it.

Addendum: Here are comments from Nick Rowe.  And from Scott Sumner.  And David Beckworth.  And Evan Soltas.  And here is my earlier post on exchange rates and the like.


I have honestly not laughed that hard in quite a while - many thanks Tyler as I needed that this morning.

If the loss of confidence in US debt is brought about by a fear of an impending alien invasion, would that be doubly expansionary?

Did you even read Krugman's post? It seems pretty clear that he thinks, given federal reserve policy, an attack by IBV would translate into a fall of the dollar exchange rate. Now that might be wrong, but that isn't the position you responded to.

At that point, a currency with less value isn't much of a consolation prize. Read Scott Sumner's response.

And this person has a Nobel Prize!

And as you noted (quoting) on Sunday:
"Serious economists whom I respect enormously find themselves taking strong positions on opposite sides of this debate.".

What would you say to a non-economist who is having serious doubts about the entire (macro-)economics profession? What could change my increasingly negative opinion? I am sincerely interested, this not as (just) snarky remark. I love how you report in a measured tone on all sides of the debates.

Thank you!

Macro-economics is not a hard science. It never has been. The data sets are too small and the historical "experiments" are too unique and uncontrolled to make it a hard science. In fact it is a pseudo-quantitative type of political science whose best practitioners frequently have political agendas and use them to reverse engineer their scholarship.

The results of macro-economic modeling exercises depend entirely on how simple the models are made, what the assumptions are, what is left in and what is left out. Frequently any type of conclusion at all can be justified by the judicious selection of a model.

In periods of little economic volatility, when the political stakes are low, there may appear to be a "consensus" in parts of the macro-economic profession in a given country. The fragility of this consensus is evident as soon as the smallest cracks in the economic well being of that particular country arise, and difficult political decisions need to be made.

The portions of macro-economics that are little disputed, and not subject to the winds of politics, are called micro-economics.

Thank you. You perfectly describe the impression I have, and which I was hoping to correct. I am aware that the lack of controlled experiments makes it a difficult field, and that models are grossly oversimplified. But I would hope from some sort of "progress", if not consensus among academics, informed by whatever data is available. Anyone cares to defend the field?

#1 - I think you are seriously misreading Gorton here (I'm reading it right now so I'm pretty much in tune with his argument). He separates out MBS and all of their derivatives which are not transparent and cannot be truly valued from Treasury issues. The erroneous thinking that all the MBS issues were information insensitive was clearly wrong and this was certainly recognized prior to the meltdown by some savvy investors who did quite well in betting that they would default. Your other points may or may not be true but 'at this point in time' Krugman's approach is valid. Depending on the how the debate about the Fiscal Cliff/Austerity or any other term you want to use turns out, things could get either better or worse.

Not Cowen's point. The valuation of MBS' were collateral and an asset base upon which financial activity was conducted. A change in the valuation caused for one thing the money market funds breaking the buck, which triggered a run on those assets, starting a cascade of events that hasn't quite come to an end yet.

A change in valuations of US Treasuries would have cascading effects that are unpredictable. Look what happened in Europe when Italian bonds went from 5-6%. For the US to do that would be end-of-the-world type effects.

The U.S. Treasury Market would be protected by purchases by the Fed with money created out of thin air.

To me, the problem with the bond attack is twofold.

The first problem is CPI targeting. If the Fed tries to control inflation of consumer imports by raising interest rates, then it will cause a recession.

If it did nominal GDP level targeting, that wouldn't be a problem. We would, however, get higher CPI inflation.

The other problem is fiscal. The government would need to raise taxes, which would be bad. Or it would need to cut some kind of government spending. That isn't so bad in my view, but it does create sectoral disruption.

And in the worst case scenario, the government gives up and goes for inflationary default.

Why not a libertarian method to settle this? Who would have had greater investment returns since the collapse: those who listened to Tyler and his Chciago types or Krugman's followers?

Tyler is a New Keynesian not a Chicago Schooler.
You clearly have not been paying attention.

Tyler would hate to be boxed in as merely a "New Keynesian", but you are right that he's not Chicago and anyone who writes as much just reveals their own ignorance.

Tyler's post starts off with, "Keep in mind we are talking about a sudden leap upward in interest rates," and most everything follows from that. Krugman's model has the Fed counteracting any upward pressure in the interest rate, ergo, there is no "sudden leap upward in interest rates," ergo, none of Tyler's points that follow are applicable.

Heck, Krugman may even agree that these points show why it could be very bad if he's wrong, but he'd probably counter by saying, "But I'm not wrong." Personally, I think Krugman is wrong, but not because of anything in this post. This is more of a list why it would be bad if he is, not proof that he is. It takes as it's starting point the assumption that Krugman is wrong.

The Fed cannot “counteract any upward pressure in interest rates” other than very short-term rates.

Tyler, You and I approached this question from different angles, but I think we agree. At the end of the day, this is a supply shock. We have to be making some heroic assumptions about monetary accommodation, the response of the US dollar to a global risk-off, the response of domestic investment to an increase in the sovereign risk premium, etc. It would be sharply contractionary. (My full post, with a model of my argument, is here:

Krugman is textbook Mundell-Fleming open economy with a floating exchange rate. There are a lot of problem's with the model but you shouldn't act surprised.

During and after the Asia crisis the Asian countries experienced devaluations from 20 to 80% (from the top of my hat, I'll check this). This seems to have been the main thing responsible for their V-shaped recovery, which is in line with the Krugman argument. Also, external devaluation does not change nominal domestic wages, which means for reasons of price as well as income that the competitive positioin of domestic companies inmproves. American apples become much more expensive - so you buy domestic electronics with your wage which did not change in a nominal sense. This last effect is absent in Greece/spain/Portugal and the lot as any increase in domestic competitivey is offset by lower wages.

Exchange rates can be found here (nominal, effective and real):

Clearly, a cheap, weak and distrusted currency is good for exports.

I think in previous decades a devaluation of US currency would have had a boomerang effect by an increase in the price of oil. However, growing US oil production is quickly mitigating the damage that would cause. So it's somewhat more viable at this point.

However, I can't begin to predict the Chinese reaction if we devalue the bonds they hold or the reactions on the worlds economy in general. A stable greenback has been a cornerstone of world economics for many decades at this point. There would certainly be some serious unexpected secondary consequences.

How much do the following things skew the model, and in which direction?

* US import market is systemically important
* Systemically important US trading partners with all-in trading strategy of propping up dollar against their own currencies
* European hard times reducing availability/desirability of substitutes

Seems like the US enjoys an implicit subsidy here due to MAD with other large economies, particularly China and Japan, that would act in important ways as a hedge against the negative factors (at least until those relationships -- which seem pretty robust right now -- also blew up). If that's right, the question kind of shifts from "Is the US insulated by having its own currency?" to "Is the US economy too big to fail?" which is a different, squishier question.

This seems to me to be a case where there's been a lot of agreement, but we're beginning to suffer from the "Wasted Time Syndrome." My fear is that, if we just continue to slog along, there will develop an urge to have some big event, and the closest at hand will do, whatever the consequences.

The way Krugman models the 'risk premium' in this instance is actually quite misleading, in my view. In his model, the effect of an increase in the risk premium has the same effect of an increase in the return rate on a risk free asset in the foreign country. This assumption has important consequences, and it's worth exploring the consequence of an increase in the latter. Higher interest abroad drives a wedge between interest rates, and therefore capital will flow in the direction of the highest one, which means lower demand for the home currency and, consequently, depreciation. Assuming that the same mechanism occurs with a higher premium for *home* domestic investment is deeply disturbing. After all, this wedge is between the domestic interest rate and the foreign one, not the other way around and, yet, they have the same results. I think the problem lies with the explanation for what underlies the shock, and here is how I would change the interpretation: for any given level of capital flowing into the country from abroad, foreign investors now demand a higher price, hence the premium. This has no effect on the demand for currency because the same amount is flowing into the country. On the other hand, higher interest has effects on the real side of the economy by depressing investment. Reduced domestic demand reduces the demand for domestic currency (we use our own coin to pay for our products) and, therefore, the price of the currency depreciates. Because the central bank cares about deviations from output, it allows that degree of depreciation and thus mitigates negative effects on output. Despite that, output still falls relative to the initial state of affairs because higher borrowing costs depress economic activity.

Arguing from a price increase is always tricky, and in this case I think Krugman makes a mistake in assuming that the higher price (premium) is accompanied by a reduction in incoming capital flows (leading to a depreciation), which then drive the rest of his results. I find that way of formalising this very muddled and, indeed, would suggest it is to a certain extent wrong: foreign investors either want a higher price for the same amount of resources, or supply less resources at every given price point. Arguing for both at once is misleading and makes no sense to me.

To an extent, that is what we have been seeing over the past few years. Yuan up relative to the dollar. It hasn't worked out too badly. Gradual shifts are probably better than sudden ones as they allow time for things to work out, but far worse are no change or change in reverse. If you swallowed the free lunches of the last decade, it would be worthwhile just to let you know they weren't free.

I have thought through what a loss of confidence of international investors in US assets means for US unemployment and well-being in the case of a government that buys so much goods with printed money until the inflation rate reaches a certain number: The results are not pretty. The US are getting poorer and assuming people do not only respond to nominal but also to real wages when supplying labor the unemployment rate will rise:

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I think you're missing the importance of 'borrowing in one's own currency'.

The US debt is denominated in US dollars. The US decides, more or less, how many dollars there are. If you're going to start talking about a sudden increase in interest rates due to Treasury holders deciding to sell their inventories of bonds at cheaper prices, then the problem is what exactly is happening to those dollars?

If they go into savings elsewhere, like putting the money in bank money market accounts, then the financial system is going to channel those funds back into the Treasuries thereby offsetting the rise in interest rates. If they go into buying goods and services, then employment in the US goes up and along with it tax revenue and automatic spending programs go down. It has nothing to do with the Fed stepping in and printing money like crazy to pay the US debt. The only way that would be necessary is if bond holders decided to sell their bonds on the cheap for cash and then held a huge bonfire where the burn up all the dollars.

We are indeed following in the footsteps of Perón's Argentina, and many other countries of that period which have engaged in runaway deficit spending.

The major difference is that there will not be any IMF or World Bank big enough to bail out the United States, after the president is done pissing away amounts of money so large even Carl Sagan couldn't describe them.

Not really addressing the point here by looking at the difference between borrowing in your own currency and someone else's. What exactly would 'bond vigilantes' be able to do to a country that borrows in its own currency? The US cannot borrow more dollars than exist and the amount of dollars that exist is decided by the US. If bond holders decided they hated US debt, what could they do with their dollars? They could buy goods and services with them, buy some other country's currency and invest there, or they could loan it to people in the financial markets. In the first case you'd get a booming economy, probably even an overheated one shrinking the deficit faster than a 100 degree day will melt a snowman. In the second case the value of other currencies would rise making their products expensive while making the US's super cheap...again leading to an economic boom but bad for anyone who wants to vacation in Europe. In the third case the financial system would just work the funds back to Treasury bonds.

The fact is borrowing in one's own currency is a vastly different case than borrowing in someone else's. Which is why the market insists on making such loans to developing countries in something other than their own currency.

Where I think Tyler misses the boat here is remembering that one actually has to work out the implications of a model, not just move one major piece without thinking how other pieces have to move in response. For example, you can't just ask what would happen if China decided not to buy any US Treasuries without asking what exactly would then happen to all those dollars China earns with its exports? They have to go somewhere?

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