I ask this as a quasi-Keynesian myself. I'm not (merely) trying to score points.
[Update 2. Paul Krugman weighs in. Like Brad DeLong, and Scott Sumner (in comments), he questions my assumption that the central bank can keep the interest rate fixed, without buying all the outstanding bonds.]
Take the standard ISLM model straight off the shelf (or straight out of the second-year textbook). Draw the LM curve horizontal; either because the central bank conducts monetary policy by setting a rate of interest, or because the economy is stuck in a liquidity trap where money and government bonds are perfect substitutes. Now let's hit it with a shock.
The shock is that all the bond rating agencies downgrade the rating on government bonds. Specifically, the rating agencies say that whereas the previous default risk was zero, there is now a 1% chance per year that the government will renege on 100% of all promises to pay money on its bonds. (Or a 10% chance per year of reneging on 10% of repayments, whatever.) And assume that everybody believes the rating agencies. Further assume that the central bank holds the interest rate on government bonds constant, by offering to buy and sell unlimited amounts of government bonds at prices commensurate with that same interest rate. [Update: but is this assumption reasonable? See comments by Brad DeLong, Andy Harless, Scott Sumner, and me, below]. Further assume that fiscal policy stays constant.
What happens?
Any good economics student who has completed intermediate macro and really understood the material and has the capacity to think (rather than just memorise results for the exam) ought to be able to take a decent crack at this question.
My answer to this question is the same as the standard textbook answer to the question where the shock is an increase in expected inflation by 1% (one percentage point, strictly).
The IS curve is drawn as a function of the expected real interest rate, because desired savings and investment depend on the expected real interest rate — the nominal rate minus expected inflation. And the LM curve is drawn as a function of the nominal interest rate. Because the demand for money is a function of the nominal interest rate, or, in this case, because the nominal interest rate is what the central bank sets.
There are three ways to handle a 1% increase in expected inflation in the ISLM diagram: first, put the nominal rate on the vertical axis, and shift the IS curve vertically up by 1%; second, put the real rate on the vertical axis, and shift the LM curve vertically down by 1%; third, put both interest rates on the vertical axis, but put a vertical 1% wedge between the IS and LM curves to the right of the intersection point. I prefer the third, "wedge" method. But all three ways give exactly the same answer. The 1% increase in expected inflation causes the ISLM equilibrium point to move to the right, to a higher level of real income and lower real interest rates. The increase in expected inflation causes the Aggregate Demand curve derived from that ISLM model to shift right in {price level; real income} space. This is standard second-year stuff.
And if you: did believe in the ISLM model; and did believe that the economy was stuck in a liquidity trap; and did believe the economy needed an increase in Aggregate Demand; and did believe that fiscal policy either should or could not be used, for whatever reason; you would say that this increase in expected inflation is a good thing.
And, at first sight, the answer to the question "what is the effect of a 1% increase in perceived risk on government bonds?" is exactly the same as the answer to the question "what is the effect of a 1% increase in expected inflation?". At least, in this model, given my assumptions. Both result in the same 1% fall in the real risk-adjusted rate of interest on private saving and investment and the same rise in AD and real income.
And the ISLM model is no straw man. Simple, yes. Crude, yes. But straw, no. No model that has survived 70 years is a straw man. Paul Krugman likes it. So do I, sort of. And it's not really that different from the canonical New Keynesian model, at least for this question.
So, why aren't US Keynesians cheering the possibility of budget impasse and the downgrading of US bonds? Or did I miss it?
That's not necessarily a rhetorical question. There may be answers. But they aren't in the model.
1. Yes, a downgrading of US government bonds would be a good thing in the short run, because it would enable the economy to escape recession, but it would be a bad thing in the long run by raising the costs of rolling over and financing the debt when the economy gets back to normal.
2. Yes, a downgrading of US government bonds would be a good thing in the short run, because it would enable the economy to escape recession, but it would be a bad thing in the long run because bond prices would fall when the economy gets back to normal and this might cause some banks to get into trouble. (But so would increased inflation).
3. A promise is a promise, and it's bad if you break your bond even if good things happen.
4. ?
Is anybody out there celebrating this rather large silver lining? Or don't Keynesians believe their own models?
Worthwhile Canadian Initiative 
I think it’s briar patch thinking. If anyone with functioning brain cells advocates anything, the Republicans will oppose it on principle. If Obama and the Dems were in favor of a government downgrade and default, the Republicans would have to oppose it. The only way to get them to go for it is to beg, “Please don’t throw me in that there downgrade briar patch”, and hope that Uncle Remus was right.
I think the problem boils down to the institutional structure, and it is very instructive to our current situation.
For example, Canada manages rates by the corridor system. It doesn’t matter if the government defaults on bonds or not, a bank will still lend reserves to another bank at a price within the corridor, because it will lose money if it doesn’t.
So bank cost of funds will not change, neither will the central bank need to go on a bond buying spree in order to keep rates low. Arbitrage will ensure that the marginal cost of reserves is what the CB dictates, and from the marginal cost of reserves, other rates will propagate.
But if banks hold government bonds as assets — which they do — then their balance sheets will change. They will suffer a huge loss of capital, so who pays? One option is for everyone to pay by paying higher (non-risk-free) borrowing rates. But that is not the best option. If the regulators swiftly close the banks and have the bank creditors eat the loss, then it need not result in higher rates on the margin. If history is a guide, regulators will not do that and they will prefer to socialize the losses. That means banks will charge higher rates to their customers and slowly recapitalize themselves, while keeping their own creditors whole. That would result in higher interest rates and lower output.
Therefore whether or not higher rates are the outcome depends on how the resulting balance sheet problems are handled. The central bank can always insure that the marginal cost of reserves is whatever they want, and they do not need to buy any bonds to do this — it’s enough to be willing to lend to banks at some rate, and to pay interest on reserves at some other rate.
And I think that this is what has actually happened. Rather than having mortgage losses borne by those who are supposed to bear them, the losses are being borne by the non-financial sector as a whole. This is equivalent to placing a tax on the non-financial sector, which lowers real output and raises real borrowing rates to a sufficient level to recapitalize the banks from the entire economy, instead of recapitalizing the banks from the existing pool of bank creditors.
ISLM doesn’t incorporate the term structure of government interest rates; nor does it incorporate central bank’s operational capability to modify that term structure through its own intervention. If the government retains the existing term structure on its debt, the market will price that debt according to perceived default risk. Other things equal, nominal interest rates will move up, adjusting for default risk. And the LM curve will shift. But if the central bank buys back all government debt by issuing interest paying reserves, it can control the nominal interest rate, other things equal. So the horizontal version of the LM curve doesn’t have to shift up.
There’s no default risk on “AAA cash” (bank reserves) in that case, because the fact that the central bank is now the main funding mechanism for government deficits removes the threat of operational default or “insolvency”, provided the central bank keeps the nominal rate paid on reserves low enough. That won’t be a problem in the early stages of AD stimulation.
The bonds that the Fed holds and the condition of the Fed’s balance sheet are not an issue for default risk. It is of no economic consequence to net fiscal math that the market would rate bonds held by the central bank AA. It is irrelevant for actual deficit financing. This is internal bookkeeping. Even if the government (treasury) chooses to “default” on these bonds, or to mark them to market for default risk (which it wouldn’t in any case), it is easy enough to recapitalize the central bank by exchanging a capital injection for an internal loan from the Fed to treasury. There is no net fiscal effect due to such internal bookkeeping, given the remittance of Fed profits to Treasury.
I think Krugman is right on the shadow rate as a concept, but he’s wrong on the interest rate implication. There’s no reason for the private debt market to price interest rates differently – whether the reference curve for risk is an actual treasury yield curve that is truly risk free, or a shadow treasury curve that includes default risk with higher interest rates to reflect that risk. Shadow rates for the risky shadow curve would increase, but rates on private debt wouldn’t change – because a contraction in the credit risk difference between private debt and treasury debt accommodates a commensurate contraction in the interest rate differential between them.
P.S. the exit strategy (if desired) for withdrawing cash (reserves) is done via either central bank liability management (e.g. term deposits) or by Treasury restarting its debt issuance (it pays down the internal loan, which extinguishes reserves). Central bank marketable assets are not required to withdraw cash.
Just when I thought I had my head wrapped around IS/LM you throw me for a loop.
Isn’t the assumption that a 1% increase in perceived risk on government bonds and a 1% increase in expected inflation will be the same rather questionable？ An change in in inflation expectations will instantly change all real interest rates the same amount. A change in the perceived risk on government bonds will only directly change the rates on treasuries and effect other interest rates in a complex hard to predict fashion.
Lee,
Jasiek’s reference is to GT Ch 15, sections (ii) and (iii). But I don’t see that it helps much; Nick’s IS-LM model isn’t closely related to that of Hicks, which in turn is some way from the GT. A discussion of this kind won’t go anywhere until we specify the menu of assets more precisely. A typical IS-LM model doesn’t distinguish private-sector bonds from government bonds.
Nick:
Bottom line: The Fed will never default on money. A default on treasuries may debase the Fed’s balance sheet which increases risk of inflation. This will devalue future money. But inflation will have exactly the same effect on the value of future treasuries since they are denominated in money. I.e. inflation can’t change the relative value of money and treasuries (a change in nominal rates can, but not a change in inflation). Therefore while credit risk will impact bonds, it will not impact money. Real bills is false.
K,
The interest rate on treasuries rises to offset inflation. The interest rate on base money is fixed near zero by the Federal Reserve.
any foreseeable ‘default’ at this point would just be a slight delay in coupon payments, and since interest rates are nearly zero, it would be a non-event from a theoretical point of view. this thread is about real default, which isn’t within the realm of possibility currently.
I just noticed that Krugman gave the same answer as I did, but he didn’t cite me. 😦
Lee: Here’s another way to think of it. Money is a perpetual zero coupon bond. The only way it can have value is for it to have some kind of convenience yield. For $1 (the medium of exchange) to have perfectly constant value (in terms of the medium of account) that convenience yield must be exactly equal to the short rate. I.e. currency is equivalent to a perpetual floating rate note with a convenience yield equal to the FF rate. There is no other coherent way to define it. So from the point of view of interest rates or inflation, holding $1 of money is exactly equivalent to holding a portfolio in which you roll $1 of T-Bill and consume the interest. Neither a change in rates, or a change in inflation can change the relative nominal or the relative real value of those two portfolios. But, if the T-Bill defaults, the money is still there. Where’s it going to go? If you insist on real bills then the government then taxes back some assets and gives them to the Fed to “back” the money. But it doesn’t matter. The Fed’s money doesn’t need backing because there is no mechanism for it to default since it doesn’t mature and doesn’t pay interest. Since it is the numeraire it merely measures the value of everything. Defaultable T-Bills do not.
All of which is to say, Krugman is right. Inflation and government credit risk are quite different. Money, inflation, and the term structure of risk free rates exist completely independently of government bonds. Government bonds are just something the CB may or may not have on balance sheet. The Fed, in fact, holds lots of bonds of non-government issuers of a variety of credit qualities. And if the Fed is being well run, it should be well diversified and have taken sufficient hair cuts against risky assets to assure that it will always have enough assets to prevent inflation (but even if it hasn’t, it doesn’t matter – see my previous comment). Oh yeah, and I take back what I said to the contrary yesterday. It was some muddled nonsense.
but are the assumptions accurate ?
If the assumptions break down, then speculation on the model is just navel gazing, not science
so, before you waste a lot of time and mental energy, supply the data that shows the assumptions are accurate enough that the model has some validty to the real world.
I’m guessing you don’t have the data, which is what separates economics from science (and even if you had the data, it would be difficult to assert that it applys to the future)
A lot of the pushback on this hinges on the option to sell bonds for cash. But why hasn’t this option been exercised already? Bonds are necessarily riskier than cash – there’s always a nonzero chance that rates could rise before the bond matures, producing a capital loss. Bonds are less liquid than cash, more or less by definition. So why is anyone holding a zero-yield bond rather than cash? And if we don’t have a good answer to that question, how can we be confident that they wouldn’t continue to hold them even with some default risk?
“So why is anyone holding a zero-yield bond rather than cash?”
Is that a serious question? I can answer it, but I don’t think that will cast any light on the ISLM model or on the beliefs of Keynsians.
If you want to hoard a considerable sum of “cash”, 100mm or more, it is impractical to do so in the form of pieces of paper. First, because once transaction and storage costs are considered, paper cash earns a negative rate of nominal interest. Second, because the “default risk” of paper cash is positive: despite all your expensive precautions, your vault could be destroyed by earthquake or fire, or be robbed. Third, because although any individual agent might be able to find 100mm or more in paper, there is not sufficient paper to satisfy the aggregate demand of all agents.
A private person might have a computer program break up his 100mm into 400 or so deposits at FDIC-insured institutions, but most large sums are held by institutions (even when the beneficial owners are in fact individuals.) These are not eligible for FDIC insurance. Consequently, even “cash” in the form a demand deposit has default risk in the ordinary sense; on a risk-adjusted basis a demand deposit earning 0% is normally worth less than a T-bill earning 0%. Banks are able to park their cash as reserves, but most institutions do not have that option either and use bonds directly (by buying them) or indirectly (by lending repo and accepting bonds as collateral.)
This use of bonds is one reason why DeLong’s sanguine view that the market will just “switch to cash collateral” is unworkable: you can’t usefully collateralize cash with cash. (There are other reasons, but they are even more tangential to the subject of the original post.)
If you want to hoard a considerable sum of “cash”, 100mm or more, it is impractical to do so in the form of pieces of paper.
OK, but this creates its own problems. First of all, for purposes of these discussions, reserves are cash too. Second, it invites the question I asked above, if there are significant costs to holding cash rather than bonds, why are we so confident the Fed can’t target a negative overnight rate?
You might then say, the Fed could target a negative rate, but for some reason it won’t. In which case a positive default risk becomes attractive as an alternative, and we’re agreeing with the argument of the original post. Right?
I post this to be corrected, but it was my understanding that sovereign borrowers by definition had the highest credit rating in their own currency. They have tax powers, issue the currency and deal with the central bank; private corporations don’t. I understand that when a sovereign borrower is downgraded, it takes everyone else in that currency down too. Private borrower credit ratings are not independent of the sovereign rating, which many on this thread seem to assume.
If the US is downgraded this can easily be empirically tested. Warren Buffett and Berkshire Hathaway make a big deal out of Berkshire’s AAA credit rating. Buffett uses Berkshire’s large balance sheet and creditworthiness to engage in large reinsurance deals. He explicitly uses Berkshire’s credit rating as a selling point to do business. So if the US is downgraded Berkshire’s rating can be watched to see if it remains AAA or goes down because the US went down.
Determinant: in principle you should be right since no sovereign issuer will ever really default except in a condition of hyperinflation, which will cause skyrocketing rates which be equally distressing for all borrowers. In practice, though, they will downgrade the US and not corporates, on the principle that even delaying an inevitable interest payment is unacceptable for a AAA issuer, and does not reflect badly on anyone else.
I have already dealt with reserves as cash. The Fed can target any fed funds rate it likes, having the ability to make an unlimited market at its own 2-way price. It can even make the actual traded market rate a small negative one, when the conditions are right. Large negative rates, though, will merely prevent the market from clearing. They can have no bearing on the ISLM model because they have no connection to LM. Krugman is in the right of that: you can make any hypothesis you like on the empty set, but it would be tendentious to assume that your hypothesis is thereby supported.
An aside: it is conventional for you economists to treat small rates, both positive and negative, as equivalent to zero. Is that wise? That is a question you must answer for yourself.
@Determinant, in addition to what K said, another practical example of a sovereign defaulting on its own currency obligations was Russia in 1998. They repudiated their short-term ruble debt and yet honoured their longer-term USD debt. This is the opposite of conventional wisdom, that a sovereign can always print its own currency, but must buy FX with real goods. But the discount rate on the GKOs had become ruinous, and once default became the least painful option, they defaulted.
Phil, I wasn’t saying that sovereigns were perfect credits by definition, my point is that they are the highest (though not perfect) credit by definition in their own currency. The US Government, 12 states or so and a dozen US corporations have AAA credit ratings. If the US gets downgraded to AA, what happens to the other entities credit ratings? Do they go down too, as the theory on credit ratings I have read leads me to believe. If so that would imply a good deal of suffering. Not to mention every other credit, mostly though those BBB or above. Credit ratings are partly a relative definition with the point of reference being the sovereign currency issuer of the debt in question.
“I’m trying to figure out if this reasoning is also consistent with the (casual) observation that poorer people buy lottery tickets, thereby voting for redistribution that increases inequality.” – Nick Rowe on in a comment on the econlog blog
Hey Nick, I know this is off topic, but I got banned from econlog for saying something disparaging about deLong’s attitude towards other bloggers.
Poor people have a very, very high effective marginal tax rate due to stacking benefit losses as income increases (it can get over 100%). This can by standard microeconomic models of risk preference make them “risk loving.”
Doc: “Poor people have a very, very high effective marginal tax rate due to stacking benefit losses as income increases (it can get over 100%).”
Agreed.
“This can by standard microeconomic models of risk preference make them “risk loving.” ”
I’m still trying to get my head around this. I think I can see it for taking risks over taxable income. Does it also work if lottery winnings are untaxed (like in Canada?), and you can’t write off lottery losses against taxable income??
This might be an important insight.
Krugman’s answer:
http://krugman.blogs.nytimes.com/2011/07/25/default-in-a-liquidity-trap-very-wonkish/
PK:
..I think this is wrong — but in an interesting way.
It’s true that, say, a 1 percent possibility that your bond holdings will become worthless within a year is similar to the expectation that inflation will erode those bonds’ real value by 1 percent over the next year. But inflation doesn’t just erode the value of bonds; it also erodes the value of cash. And that’s why expected inflation can help in a liquidity trap: it makes sitting on cash less attractive. The threat of default doesn’t do that. As far as I know, we’re not talking about a loss of confidence in pieces of paper bearing pictures of dead presidents. And that’s why the threat of default isn’t equivalent — and not expansionary.
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