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 et.al. 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.

Let’s continue our look at debates over UK fiscal adjustment.

Will fiscal policy work in an open economy? The standard view has
been that in a Mundell-Fleming model fiscal expansion appreciates
the exchange rate and hurts the trade balance, thus offsetting
the fiscal policy. The U.S. may be too closed an economy for this
to be a big deal, but for the UK it seems this might apply, at
least if one is operating within Keynesian frameworks.

The recent Keynesian response has cited the “lower bound” as a
reason why fiscal policy still may be effective in an open
economy. But what does this literature really show? Let’s take a
brief tour of it, starting with the August 2012 piece by Emmanuel Farhi and Ivan Werning,
brilliant Harvard and MIT guys. Their piece is clear and
excellent, and it shows what the case for fiscal policy in this
setting looks like. (I don’t read them as offering concrete
advice to current governments and thus I have no criticism of
their paper, which I am pleased to have spent time with.)

Here are a few points:

1. “…the effects of government consumption work through
inflation.” In other words, if you think the BOE has greater
influence over inflation than UK government spending, you do not
need the other results of this paper for macro policy. I get the
point of “the central bank cannot precommit to elaborate
targeting schemes over time,” but that’s not what we need here.
We just need some basic money-induced price inflation to render
monetary policy dominant over fiscal policy, even in this case.
And pretty much everyone thinks the BOE can influence the rate of
price inflation. The rates of price inflation we are getting are
not some kind of strange coincidence.

By the way, even with a so-called liquidity trap, the BOE also
can play QE with the exchange rate, as do the Swiss.

2. The zero bound open economy model predicts that fiscal
tightening leads to exchange rate appreciation (contra the usual
Mundell-Fleming case), yet here is the British pound against the
dollar:

Not an obvious fit to the prediction. There are countervailing
factors, to be sure, but maybe that’s the broader story too.

3. The model in the paper suggests that “current” fiscal policy
won’t much help aggregate demand. Fiscal policy does best the
further away in time it is, provided it does not happen
after the liquidity trap goes away. This makes sense if you view
inflation as the channel for the effectiveness of fiscal policy.
Getting the inflation over with won’t help much, but if it hangs
over people’s heads they will spend more in response. In fact
there is even a problem that the multiplier can be infinite if
fiscal policy is sufficiently well-time and back-loaded.

None of this corresponds with the advice we actually are hearing.

4. The greater the nominal stickiness of prices in the model, the
weaker the Keynesian effects and in the limiting case they
approach zero. Yet we are told (by the policy commentators) that
nominal stickiness is of the utmost importance.

Let’s consider a few other pieces and points:

5. It is common for these papers to rely on squirrely mechanisms
of intertemporal substitution, which in other contexts are mocked
by Keynesians. Consider
Fujiwara and Ueda, a commonly cited paper on fiscal
multipliers and the zero bound:

Incomplete stabilization of marginal costs due to the existence
of the zero lower bound is a crucial factor in understanding
the effects of fiscal policy in open economies. Thanks to
this, government spending in the home country raises the
marginal costs of home-produced goods, which increases expected
inflation rates and decreases real interest rates.
Intertemporal optimization causes consumption to increase, so
that the fiscal multiplier exceeds one. While government
spending continues, the price of home-produced goods increases
more than that of foreign-produced goods. Expecting that two
countries are at symmetric equilibrium when government spending
ends, the home currency depreciates and the home terms of trade
worsen on impact when government spending begins. That shifts
demand for goods from foreign-produced goods to home-produced
ones. The fiscal spillover thus may become negative depending
on the intertemporal elasticity of substitution in consumption.

If a passage like that came from an RBC theorist it would be
mocked, but in support of activist fiscal policy it passes
without critical comment.

6. When it comes to Japan and the Japanese lower bound, the
empirical evidence seems to show that “standard theory” predicts
quite well and the stranger zero bound theories do not predict
well. Here is Braun and
Korber:

We show that a prototypical New Keynesian model fit to Japanese
data exhibits orthodox dynamics during Japan’s episode with
zero interest rates. We then demonstrate that this
specification is more consistent with outcomes in Japan than
alternative specifications that have unorthodox properties….

Those same zero bound Keynesian models predict that economies
should have quite volatile responses to real shocks, yet they do
not:

We also considered specifications of the model that have larger
government purchase multipliers and some which also exhibit
unorthodox predictions for the response of output to labor tax
and technology shocks. We found that these specifications are
difficult to square with the fact that the period of zero
interest rates in Japan between 1999 and 2006 was a period of
low economic volatility. All of the specifications predict the
opposite should have occurred. The specifications with
unorthodox properties also have other problems. They predict
large resource costs of price adjustment which are difficult to
reconcile with empirical evidence that menu costs are small and
they require that households expect the period of zero interest
rates to be counterfactually long.

Need I state the irony that proponents of the relevance of the
zero bound often insist that real shocks simply aren’t making
such a big difference in recent years? That is inconsistent with
the basic model which they otherwise are citing.

7. In these settings (and assuming away all the problems above),
a lot of the effectiveness of fiscal policy, or sometimes all of
it, comes from “beggar thy neighbor” effects. Read Cook
and Devereux for some illustrative cases. Beggar thy neighbor
strategies are criticized and rejected when Germany (supposedly)
does them through its export prowess, but in the context of
fiscal policy they seem to be given a free pass.

8. In fact I could make further points but I believe that is
enough.

The bottom line: A look at this new and
interesting literature shows it does not support the
interpretations which the “policy commentariat” Keynesians are
putting on it and in some regards it even opposes those
interpretations. When it comes to UK fiscal policy, we are seeing
again what I described
last week: exaggeration and a lack of transparency in
argumentation.