The bond vigilantes with a floating exchange rate

Paul Krugman writes out a simple model (pdf), source here, and summary here: “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.”

I see it differently.  The confidence loss brings upward pressure on the real borrowing rates, and the Fed pumps out money to keep the short-run nominal interest rate down (have zero lower bound issues gone away?).  Because of expected price inflation, the long-run nominal interest rate goes up and the medium-run interest rate goes up too.  The long and medium real interest rates go up and stay up.  There is no long vs. short-run interest rate distinction in Krugman’s model.

Exactly what happens with short-run interest rates depends on credibility and how much inflation the public is willing to accept.  I would say this: the counterfactual of a bond vigilantes attack already means the public refuses to turn over much more of its wealth to the government.  So most likely we have higher medium- and long-term real and nominal interest rates and chaos on the short rates, with no pretty scenario in sight.  Eventually the short rates probably will rise too.

I do see that Krugman has written: “…inflation and expected inflation could matter, but I don’t think they do in this case, so that I suppress them for the sake of simplicity.”  In essence, in his model, the central bank can push down “interest rates” (in general) without bearing any inflation repercussions.  Of course that eases the problem but it seems oddly unremoved from the real world problems of central banking.

A few years ago, Brad DeLong wrote correctly:

International finance economists see a far bleaker future. They see the end of large-scale dollar-purchase programs by central banks leading not only to a decline in the dollar, but also to a spike in U.S. long-term interest rates, both nominal and real, which will curb consumption spending immediately and throttle investment spending after only a short lag.

To be sure, international finance economists also see U.S. exports benefiting as the value of the dollar declines, but the lags in demand are such that the export boost will come a year or two after the decline in consumption and investment spending. Eight to ten million workers in America will have to shift employment from services and construction into exports and import-competing goods. This cannot happen overnight. And during the time needed for this labor market adjustment, structural unemployment will rise. Moreover, there may be a financial panic: large financial institutions with short-term liabilities and long-term assets will have a difficult time weathering a large rise in long-term dollar-denominated interest rates. This mismatch can cause financial stress and bankruptcy just as easily as banks’ local-currency assets and dollar liabilities caused stress and bankruptcy in the Mexican and East Asian crises of the 1990’s and in the Argentinean crisis of this decade.

That is followed by a very good short discussion of inflation and monetary policy, consistent with my views above.  Brad closes with an excellent bit, including:

Serious economists whom I respect enormously find themselves taking strong positions on opposite sides of this debate.

So I am baffled when Krugman writes: “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.”  And then he writes:

So what are the fiscal fear types thinking?  Basically, they aren’t.

Only a few years ago, Krugman had a well-worked out and indeed quite admirable version of a problematic scenario, starting on p.454 and running through the conclusion, where it is presented as plausible, including by his commentators.  Note that this isn’t a “does Krugman have the right to change his mind?” issue (of course he should and he did change his mind on the likelihood of such an attack coming soon).  This is a theory question, where we consider the assumption of a vigilantes attack, and work through the theory, while admitting it probably is not imminent.  The theory hasn’t changed in the last five years, and Krugman’s current discussion hasn’t caught up with the theory from five years ago.

If you would like data, here is Ricardo Hausmann on the Latin American move to floating systems and how it has affected their financial crises:

This paper attempts to assess the performance of alternative exchange rate regimes in Latin America relative to the benefits they are theoretically supposed to deliver. We will test empirically whether flexible systems allow for better cyclical management, more monetary autonomy and improved control of the real exchange rate. We find that flexible exchange regimes have not permitted a more stabilizing monetary policy but instead have tended to be more pro-cyclical. In addition, flexible regimes have resulted in higher real interest rates, smaller financial systems and greater sensitivity of domestic interest rates to movements in international rates.

Post eurozone crisis, the fixed rates probably look worse again in a broader data pool, but still there is plenty of well-known, mainstream evidence that floating rates don’t always give such an expansionary response to a financial crisis, even if they sometimes do.  Again from the Hausmann paper:

…interest rates moved the least in countries with no exchange rate flexibility! In Argentina and Panama there were very small movements in the domestic interest rate. In contrast, countries with formally floating systems such as Mexico and Peru saw very large interest rate movements. The same can be said of Chile, which started the period with a very wide exchange rate band.

This doesn’t boil down to the usual ideological disputes.  If anything, I am taking the position more skeptical of the claims of Milton Friedman.  It’s simply that, with the fiscal cliff approaching, I see an Orwellian memory hole here.


I would interpert Krugman to be addressing a situation of less than full employment. At full employment, a decresed appitite for USG bonds could not be expansionary in real terms. That he is thinking about a situation of unemployed resources is probably signaled by "inflation and expected inflation could matter, but I don’t think they do in this case." At full employment a decreased appitite for USD securities could not be other than bad news (unless the rate of return on ivestment had been driven far below its long term equilibrium and adjustment costs were high.)

Some of the initial "pick-up" can be in q, rather than p, but still it is evident that the contractionary effects of the confidence loss can be larger than the gains from depreciation.

Strange how one system has a consistent problem with posting - originally, I thought it related to posting time, but probably, another explanation is necessary.

' “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.”'

Actually, oil imports come immediately to my mind - if the dollar cannot buy the 1/3 total of oil used per day in U.S., the rest is just handwaving in a collapsed economy.

' In fact, more than half of the total 2011 trade deficit – 59.4% can be attributed to oil imports. Imported oil has long accounted for so much of the trade deficit that economists often refer to the non-oil trade deficit as a measure of shorter-term trends in the economy.

There are several reasons why it’s also important to focus on the oil trade deficit. For one, the trend is worrying. Oil as a percentage of the total trade deficit has gone up every year since 2002, when it accounted for 19% of the total. Imported oil’s share of the recent trade deficit is the highest it has been since 1992. And if you’re wondering about actual dollar amounts, the U.S. spent $331.7 billion on imported oil last year. A rise in oil prices, which is often seen during an economic recovery, would mean an even larger trade deficit.'

(I'm sure that the link above will meet with the approval of discerning Mercatus Center devotees - 'The CEA was created in the late 2000s by Michael Whatley, a founding partner of a Washington, D.C.-based Republican lobbying group HBW Resources that has close ties to the Alberta, Canada tar sands industry. In a January 25, 2010 pro-industry strategy proposal to an Alberta government official, Whatley wrote that he was interested in "conducting a grassroots operation" in "target states" that would "generate significant opposition to discriminatory ow carbon fuels standards" that were created to address climate change. Whatley created the CEA with backing from big energy producers BP, Chevron, ExxonMobil, Marathon, Shell and the Norwegian energy company Statoil. Despite it's backing by big corporations, the group claimed it provided "a voice for consumers interested in vital public issues."' )

What "system" are you talking about?

And your post is rambling, but my take away is th

That you agree with Cowen and not Krugman?

"Expansionary fall in the dollar"? Isn't this a crude pseudoeconomics conceit?

Also doesn't it beg the question? 1) assume low inflation 2) assume people start throwing money at our stuff 3) great, because more money is more AD, 4) still no inflation and thus no increase in interest rates. Or is it simply placing a high premium on the short-term and not concered with 4?

Not a crude pseudoeconomics conceit?

1) Given current conditions, low inflation is a reasonable assumption

2) If our stuff is cheaper, more should buy it. Lower price -> higher quantity is rather basic

3) More AD is good under current conditions

4) When growth and employment improve, actions can be taken to lower the consequent rise in inflation and rates. Until then, inflation and rates are not likely to be a problem, under this sort of model (look at recent growth in base money and current inflation and rates if you think this is unrealistic).

You are ignoring the costs of volatility. Assume that exchange rates in such a situation plot out to something similar to the s&p 500 or some other similar volatile number. Do you know how exporters work in countries where that is a fact of life?

Simply put, you have two alternatives. Primary resource exports such as commodities. Or you import components from your destination market, value add something like assembly or the like then export it back. Your currency fluctuation hedge is the sales contract length of term being no longer than your source import-value add-export cycle.

Now tell me what destination market is open to US exporters that would work for them. The US has been for a long time the destination for this type of arrangement.

No, such a change in exchange rate assumptions brought about by a loss of confidence would mean a multi decade long readjustment in world economy flows of goods and capital.

Krugman's model is "oddly unremoved" from the real world, hmmm?

Models with certain predictions are best refuted with practice, and if not available, then with another models delivering different predictions. Got any models?


A few years before the 2008 crisis someone wise suggested that the US financial system was looking very much like a third world setup. Now we have a serious economists writing in a prestigious paper that devaluation won't be so bad, we can print our own money. This is pure silly season stuff.

When Argentina defaulted its currency was pegged to the dollar.

I hate the term bond vigilante. I don't own any treasuries, but I don't feel like a vigilante. It seems like an exceptionally charged word to use to describe a lack of interest in something.

I think Krugman means it ironically

Looking at Krugman's model it seems to me that throwing in the Taylor rule lets him offset anything bad and then he just gets the secondary effects, such as export increase through devaluation. It seems unwise to throw an "offset to anything bad" in your model and then work only with the remainders. For something as big and rare as sovereign default tossing out the first order effects probably leaves you susceptible to model error, like ignoring inflation, or short term vs long term.

You then end up with nonsense that bond vigilantes and threat of sovereign default are good things because output goes up. It seems then debt is a free lunch - lets run it up until the vigilantes come and then reap the rewards of increased output.

This seems so off I must have misread Krugman's paper. Did I miss something?

Im not seeing the connection between the fiscal ramp and possible interest rate spikes.

1)Treasury issue, when not purchased by the public or a foreign currency holder, is purchased by the Federal Reserve and potentially sterilized. The Fed issued dollars remain in the economy which increases price levels.
2) Having debt forgiven is a further incentive to borrow. The Treasury acts as if is hasn't those outstanding debts and issues more in order to reach the level of debt with which it is comfortable (*it* being the agents that make up the Treasury Dept). [This is easier to observe historically when the USG wasn't always borrowing more than half of the outlays.]
Nominal interest rates reflect the opportunity cost of lending, which is dependent upon real output, and inflation, which is dependent upon the quantity (and velocity) of money. So, increasing the money supply by the two influences above will increase inflation and put upward pressure on interest rates.

Grand, but what's that got to do with the deficit reduction that will occur with the fiscal ramp?

This post has advanced my understanding of the issues at debate between you and Krugman far more than any other (including those written by him). Thank you very much.

Eight to ten million workers in America will have to shift employment from services and construction into exports and import-competing goods.

So now we worry that we will have those valuable production jobs back but we won't be able to do them any more? Its funny how problems do a turn around.

" In essence, in his model, the central bank can push down “interest rates” (in general) without bearing any inflation repercussions"

This really is the key, crux of the entire debate. What latitude does the Fed have in imposing -ve real rates across the long end of the term structure and getting away with it. For how long? Given the 'money' nature of US long bonds, globally speaking, the answer probably is, a lot. As a cherry on top is the-ve beta hedge nature of long govvie bonds, generally speaking.

Combined, this means that Krugman will probably win the empirics and get to mock at the entirely legitimate nature of your critique and central bankers' concerns. And that really is the problem with his Solow-style toy models. They 'work' but they know not why they work.

But there is a deeper *Milton Friedman's thermostat* style problem with the conditional question that you set up. How would you ever know whether the bond vigilantes never came, or whether they came and were defeated? The data would look roughly the same in either case.

Did Tyler ever jump on the whole 'hyper inflation" is right around the corner game that was so popular in 09, 10 but isnt heard of as much today or is he just in his own "everything will suck for a while no matter what due to technology" ?

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:

As I learned it, absent a crisis.... if debt issuance is greater than domestic demand at the current interest rate, rates rise / foreign investors step in to buy US debt driving UP the dollar, increasing the trade deficit, and stagnating growth. Eventually debt service must be paid back to those foreign investors diving the dollar ultimately lower, but that could take years.

I don't understand this. We're still only a few years beyond a country with "ts own currency and a floating exchange rate" going so bankrupt that it literally couldn't buy paper to print bills at any order of magnitude. We know it is possible, in the most concrete way possible.

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