Paul Krugman is right if he is talking about a small attack by the bond vigilantes. It's a good thing, because it increases Aggregate Demand, which is what the US economy needs.
But too much of a good thing will be a bad thing.
A large attack by the bond vigilantes would be a bad thing, because it would increase Aggregate Demand too much. That would force the Fed to increase interest rates a lot, and that would force the US government to raise taxes and/or cut spending to cover the increased costs of servicing the debt.
If the bond vigilantes suspected that the US government could not or would not raise taxes and/or cut spending to cover the increased cost of servicing the debt, the bond vigilantes would all attack en masse.
If the debt were small, the amount by which taxes would need to be raised and/or spending cut to cover the increased debt service costs would be small too, and it could easily be done. But if the debt were large, the amount by which taxes would need to be
raised and/or spending cut to cover the increased debt service costs
would be large too, and it could not easily be done.
The longer the US stays in recession, with a large budget deficit, the bigger the debt will grow.
This does not look to me to be a very stable system. And the longer the bond vigilantes wait before attacking, the less stable it looks.
Japan looks even less stable than the US.
The bond vigilantes will eventually attack and rescue the US and Japanese economies from recession. But every year they wait before attacking, the bigger that attack will be. And they won't attack until they have grown bigger than we would want them to be.
To my mind, this reinforces the urgency for something like NGDP targeting. We don't want to wait for the bond vigilantes.
Worthwhile Canadian Initiative 
Different people have different conceptions of how government debt works. To some, government debt is a junior liability. Money is a senior liability. An excessive public debt (assuming most of the debt is bonds) then results in default risk but no inflation. No AD boost. This is I guess the more traditional view and what most people mean by “bond vigilantes”?
And then there’s the fiscal theory of the price level / MMT view that regards money and bonds as equal government obligations, and so an unsustainable public debt causes a rise in the price level rather than an appearance of default risk.
“The bond vigilantes will eventually attack and rescue the US and Japanese economies from recession. But every year they wait before attacking, the bigger that attack will be. And they won’t attack until they have grown bigger than we would want them to be.”
Oh, yeah?
I observed the attack of the bond vigilantes in the late 1980s. The trigger for the recurrent attacks was unemployment falling below 7% or threatening to do so. I would not count on them to rescue any economy.
Nick: because it would increase Aggregate Demand too much. That would force the Fed to increase interest rates a lot, and that would force the US government to raise taxes and/or cut spending to cover the increased costs of servicing the debt.
Increased demand by definition increases taxes and reduces. That is in absolute measures, not in %. Why do you still say that it would force the US government to do anything? I can play golf all day long and budget deficit might even turn in surplus if demand really increases Too Much? What is the problem?
The “max-min” stuff above is really funny 🙂
sorry guys. but could not help 🙂
Nick, pls delete if you mind
How could the federal reserve be “forced” to raise interest rates?
One would have to ask: Is the government debt serviceable in U.S Dollars or in the currency of the country who owns it/where the person resides? For example, china keeps their currency low because they get more of their currency for each one of our dollars. Would the difference with the worth of our exports(the rise in income from being able to keep or even lower the price for our exports and still maintain or increase our profit margin) off set much of the problems you refer to?
Nick, please tell me if I correctly understand the issues here.
1) Krugman clearly says he’s disregarding inflation. You’re arguing that inflation matters if the speculative attack is big enough. Okay…I assume you’re talking about the impact of the USD depreciation on the US inflation rate. But are you talking about the direct impact of that depreciation on the US price level? or the indirect impact of a real depreciation on US competitiveness and subsequent inflation via excessive aggregate demand? or both?
2) To get higher interest rates, are you assuming that the Fed responds by ignoring the dual mandate and just targeting inflation (or the price level)? or are you worried that a depreciating dollar itself makes bond traders demand an interest rate premium on the USD as compensation for future expected inflation?
3) Sergei notes (above) that higher AD improves government balances while you note that higher interest costs cause them to worsen. The net effect will depend on the relative size of these channels. What arguments suggest to you that one is larger than the other? I’d note that interest rate hikes start to affect debt service costs only as the debt is rolled over. I think most countries that are hit by the kind of debt service/interest rate spiral you describe (under floating exchange rates) have faced a long period of increasingly steep yield curves and respond by aggressively shortening the average maturity of their govt. debt, making their deficits more sensitive to interest rate changes. Isn’t that quite different from what we’ve been seeing in the behaviour of US yield curves and average debt maturity these past few years?
You know that you’re picking a fight with a Nobel Laureate whose prize citation mentions his seminal work on exchange rate crises. If you want to press the attack here, it will probably be in your self-interest to be very clear about your reasoning.
One other thing you might want to think about…..
If the bond vigilantes attack the USD, the US will be the least of your worries. A suddenly weaker US dollar against other world currencies implies a suddenly stronger Euro and Yen (all that extra AD that the US gets is just being transferred from other economies) thereby making the weakest major economies weaker still. The impact on a shaky banking system without a clear lender of last resort is something that would worry me more than the impact on the US.
At the same time, the depreciation of the USD would cause hundreds of billions of dollars of losses on the multi-trillion dollar hoard of USD claims held by the Chinese, I would also doubt that their banking system could withstand that without a massive intervention by the state. A potential banking crisis in Europe is bad enough without another potential one at the same time in China.
Of course, worries about those potential banking crises could make investors prefer….USD!
Simon:
1. both. Too much AD causes too much inflation. That is true in both open and closed economies, though the mechanisms are slightly different in the two cases.
2. both. If AD is too high for any determinate path for the price level, at current real and nominal interest rates, the Fed will have to raise real and nominal interest rates to prevent an eventual explosion of the price level path. Standard Howitt/Taylor Principle. PK already (partly) has that effect in his model, when he includes the Fed’s reaction function with r responding to Y. (I would just add inflation to the Fed’s reaction function, which he has suppressed for simplicity.)
3. Empirically, the US budget was in deficit even before 2008, IIRC. A plausible assumption is that recovery would mean returning to that same primary deficit, plus the total deficit would be bigger because the debt/GDP ratio has increased since then. Right now the interest rate is below the growth rate of GDP, so the bond vigilantes have no worries whatsoever about debt/GDP as long as r stays below g. But if r rises above g the LR government budget constraint bites, and the government must be expected to run a present value of primary surpluses equal to the current debt. The bigger the debt/GDP ratio, the greater the eventual natural rate of r when the economy recovers (standard OLG model result). And the longer it takes before it recovers, given current deficits, the bigger the debt/GDP grows, and the bigger the jump in r when it does recover.
Having long average maturity of the debt reduces rollover risk and gives the government more time to respond to a rise in r by raising taxes and cutting spending. So the risk of a sudden attack is lowered. But the government must still eventually respond.
Bottom line: we don’t know what the maximum sustainable debt/GDP ratio is. It depends on the government’s ability (both economically and politically) to run primary surpluses, and on the parameters of the economy that determine the elasticity of the natural rate of interest with respect to the debt/GDP ratio, and on the growth rate of GDP. But we know it exists, and we know the US debt/GDP is increasing over time.
The UK has had 200% debt/GDP ratios several times, and has survived (though last time, post WW2, it survived largely through inflating away the debt/GDP ratio, and that is something that’s a lot easier if popular memory still thinks in terms of gold standard price level dynamics, which it doesn’t any more). But politically the US is not what the UK was. And the population growth rate was higher then. And Japan’s debt/GDP is above 200% (though I can’t remember if that’s net or gross), and Japan’s demographics don’t look so good.
(4.) This isn’t really about exchange rate crises. It would be easier to model what I’m talking about in a closed economy. And PK does seem to have a bit of a blind spot in thinking about the implications of debt in an OLG model.
Max: yep. I’m thinking more about inflation risk than default risk, because the US is not like Greece.
Min: Yes, today is very different from the 1980’s. But if the bond vigilantes did attack, tomorrow would look a lot more like the 1980’s.
Sergei: see my response to Simon.
(Yep, I confess I have gotten Max and Min muddled in the past. Crappy joke: I forgot to check second order conditions. Sorry.)
nathan: ?? because if it didn’t, and if AD stayed too high, the price level would (eventually) explode. Standard macro model result, goes back (at least) to Wicksell.
Verner: you lost me. But the effects I’m talking about would be there in a closed economy too.
(Ugh….5:30 am here on the wet coast….)
“3. Empirically, the US budget was in deficit even before 2008, IIRC. A plausible assumption is that recovery would mean returning to that same primary deficit, plus the total deficit would be bigger because the debt/GDP ratio has increased since then. ”
Disagree. (1) Bush tax cuts will have expired. (2) There have been further cuts in non-entitlement programs that will not automatically be restored as demand expands. (3) The wars are over and the soldiers are coming home. (4) Obamacare saves money. (5) Debt has been rolled over at lower rates. Where are the increases in the primary structural deficit that you think offset these factors?
In addition, if you’re assuming intolerable levels of demand-driven inflation, aren’t you thinking of cyclical pressures way beyond those of 2008? and therefore much better cyclically-unadjusted deficits?
I think that the problem with the Krugman analysis is that he has one interest rate. The Fed controls short term interest rates and this is probably what affects the dollar, but it is the long-term interest rate that affects domestic demand and it is long-term interest rates that have the “p” term. Risk goes up–U.S. long rates go up and the short rate and exchange rate are little changed (holding inflation constant as in Krugman).
“Bottom line: we don’t know what the maximum sustainable debt/GDP ratio is… But we know it exists, and we know the US debt/GDP is increasing over time.”
“To my mind, this reinforces the urgency for something like NGDP targeting. We don’t want to wait for the bond vigilantes.”
Okay, now I’m confused. I originally thought you were talking about something that you felt was urgent. But reading your latest, I get the feeling that this is something that might not happen for a generation.
I agree with you that PK doesn’t worry much about debt-dynamics. To give the professor his due, he pretty frequently says that they have to be addressed in the vague-not-quite-yet medium term. So are you agreeing with him on that? Or are you trying to make the case that the US situation is “urgent”?
“This isn’t really about exchange rate crises. ”
Nick, if you want to make the above claim, then I’m more confused than ever. PK is explicitly talking about a model with exchange rate reactions and you are taking issue with his analysis. I don’t understand why a speculative attack in a closed economy is considered to be so excessively expansionary that it generates inflation. I thought PK’s model hinged on the exchange rate depreciation redistributing AD internationally. Could you please explain?
Must….sleep……more…..
Simon: demographics (aging boomers) would be one big effect going the other way. But sure, I would certainly claim no special knowledge about the US fiscal position. If you think that recovery would cause the US to swing back into overall budget surplus (with debt service costs adjusted for inflation plus long run real growth) then there’s nothing to worry about. Yet. But the math tells us that can’t be true forever if the debt/GDP ratio keeps on growing while we are waiting for the bond vigilantes.
ran: I see that as a complication that shouldn’t affect the basic results.
Nick,
“A large attack by the bond vigilantes would be a bad thing, because it would increase Aggregate Demand too much. That would force the Fed to increase interest rates a lot, and that would force the US government to raise taxes and/or cut spending to cover the increased costs of servicing the debt.”
It would force the government to change its financing and / or spending decisions, but you only listed two possibilities. Here are a couple of others:
1. Extend the duration of debt. Most government bonds are accrual type, meaning they don’t make coupon payments. Instead they pay back interest and principle at maturity. And so, the federal government can escape the cash flow problem of higher interest rates by extending the length of time government bondholders must wait before they are repaid. Currently the average duration of the U. S. federal debt is something like 4-6 years.
1a. Paul is wrong if the federal government choses this route. If long term interest rates rise above the rate of inflation AND the federal government extends the average duration of its debt, then aggregate demand will fall. More than likely savings rates will rise.
2. Sell equity instead of debt. Government bonds (courtesy of the 14th amendment to the US Constitution) are guaranteed claims against future tax revenue. The federal government could just as easily sell non-guaranteed (equity) claims against the same tax revenue. This has important implications for productivity and the after tax cost of money in the private sector.
Max, you said:
“Different people have different conceptions of how government debt works. To some, government debt is a junior liability. Money is a senior liability. An excessive public debt (assuming most of the debt is bonds) then results in default risk but no inflation. No AD boost. This is I guess the more traditional view and what most people mean by “bond vigilantes”?”
I guess that would depend on your view of monetary policy. If you believe that monetary policy is truly independent from fiscal policy, then the currency is a liability of the monetary authority and government bonds are liabilities of the federal government. Federal debt is a senior liability of the federal government, meaning payments on it supercede all other government expenditures.
Long term government debt is often purchased by banks who borrow short to lend long (maturity transformation). That works as long as the short term interest rate set by the fed is less than the long term interest rate. Default risk can appear in bid to cover ratios at government bond auctions. Suppose an independent federal reserve (Not Bernanke and Fisher) decides enough is enough and pushes short term interest rates significantly above long term interest rates (inverted yield curve). Borrowing short and lending long is no longer profitable. This would affect the federal government’s ability to rollover its existing debt (old bondholder is paid back by selling new bond).
“And then there’s the fiscal theory of the price level / MMT view that regards money and bonds as equal government obligations, and so an unsustainable public debt causes a rise in the price level rather than an appearance of default risk.”
Excessive public debt creates inflationary risk because the federal government can create a demand for goods (by borrowing money) without adding to the supply of goods. That increased government demand is offset by the monetary authority pushing interest rates on government debt above the rate of inflation.
Simon: PK has a Mundell-Fleming model, and models the attack as shifting the BP curve up, which increases AD if the exchange rate is flexible. You can ignore the BP curve, model the attack as an increase in expected inflation, stick a wedge between the IS and LM curves, and get exactly the same (qualitatively) increase in AD. It doesn’t matter (for my point here) which way you model the attack – open or closed economy. What does matter for my point is how big that attack is, and how much AD increases, and how much r rises, and how that affects the overall budget deficit. And the magnitude of that effect depends on the debt/GDP ratio, which is growing over time while we wait for the attack.
If you see an enemy waiting to attack, and every year he grows bigger, but you think he won’t attack until he’s big enough to win, is that an urgent problem? It’s certainly one you want to deal with sooner rather than later. Make him attack now, by NGDP targeting. Tease your enemy mercilessly. Fart in his general direction, don’t make soothing noises. (Sorry, Holy Grail references).
Nick,
“Having long average maturity of the debt reduces rollover risk and gives the government more time to respond to a rise in r by raising taxes and cutting spending. So the risk of a sudden attack is lowered. But the government must still eventually respond.”
Only if you believe that there is a limit to how long someone will lend the federal government money. Obviously that would be the case of an individual investor that has only a lifetime. But that would not be the case for institutional investors. I believe that Japan sells 50 year bonds. Would 100 year or 200 year bonds be out of the question?
This all comes down to how and when demand-pull inflation will materialize. If we’re going to be serious about all of this, it seems we need to stop talking in generalities and actually model this stuff in a rigorous fashion. When, how, and why will X amount of spending cause X amount of inflation? What are the sensitivities and what do we need to believe for X to occur given how the economy may evolve? You need these details to truly understand the trade-offs and make good public policy decisions. To my understanding, no one is really doing this. There are people like Krugman saying spend now and cut later; there are people like you saying that this is dangerous; there are people saying people like Krugman and you don’t really understand how govt spending impacts the economy. Is this not a huge gap in the research agenda?
In any case, the underlying tone is that the US/Japan wouldn’t be able to cut spending or increase taxes enough to counteract stimulus from interest on the debt. I don’t think that is a good assumption. We’re already concerned about a debt crisis when the economy is nowhere near full capacity. Something tells me we’d act when there’s an actual debt crisis.
Good post. This reinforces a point I keep making. Monetary stimulus is not “risky” as the Fed sometimes claims, rather slow NGDP post is highly risky.
Scott
“If you see an enemy waiting to attack, and every year he grows bigger, but you think he won’t attack until he’s big enough to win, is that an urgent problem? It’s certainly one you want to deal with sooner rather than later.”
Um…..no. (Seriously? That’s all you’ve got?) Logic, please, Nick.
If I’m an elephant and my enemy is a mouse that is growing, I do not need to deal with the problem “sooner rather than later.” Particularly if action in the short-term is likely to more costly than action in the medium-term.
The logic you’re using here can be used just as easily to make the case for Massive Fiscal Contraction Now. If you think slow NGDP growth is highly risk (as Scott Sumner does, above), that’s probably the last thing that you want to do.
Simon: “The logic you’re using here can be used just as easily to make the case for Massive Fiscal Contraction Now.”
No it can’t. We want the bond vigilantes to attack now, not later. We don’t want to do anything that would cause them to wait even longer. The whole point of NGDP targeting is to provoke an attack now. We want the bond vigilantes to say (and say it now, not later) “NGDP is going to rise, so it’s time to dump bonds and buy real assets.”
“It doesn’t matter (for my point here) which way you model the attack – open or closed economy. What does matter for my point is how big that attack is, and how much AD increases, and how much r rises, and how that affects the overall budget deficit. And the magnitude of that effect depends on the debt/GDP ratio, which is growing over time while we wait for the attack.”
Thanks, at least I think I understand more clearly the mechanism that you’ve got in mind. But I still don’t get your point that “What does matter … is how big that attack is…” Nick, you just explained a linear model, but I thought you were claiming a non-linear effect (small shocks good, big shocks bad.) Is this a debate about whether any AD shock causes the actual fiscal deficit to grow or shrink? Or have you got a non-linear Phillips Curve in mind (so that we don’t get rapid expected deflation from a big output gap but too much AD would generate big expected inflation)?
“No it can’t.”
Read what you wrote. You argued that if you face a growing enemy, it should be dealt with sooner rather than later. That’s the argument for We Must Balance The Budget Now. You clearly mean something else.
What I think you’ve done is confuse attack size and attack timing. Your original argument was about the size of the attack. Now you are arguing about the timing of the attack.
Simon: very briefly, because convocation is today:
Welfare is non-linerar in AD. Too little AD we get recession; too much AD we get hyperinflation. Absolutely standard assumption there.
But we want the enemy to attack. Because we want recovery, and recovery will both cause and be caused by the attack. Recovery and attack come together. But we don’t want the attack to be so big it overwhelms us.
Size is a function of timing. The later the attack comes, the bigger it will be. I wish they had attacked sooner, but we can’t do anything about that now. But we can get them to attack this year, which is better than next year, which is better than the year after.
We want an attack now, not later, not just because we want to end the recession now. But because a later attack would be bigger than an earlier attack.
BTW, I’m not sure there is anything here that PK would really disagree with.
“If you believe that monetary policy is truly independent from fiscal policy, then the currency is a liability of the monetary authority and government bonds are liabilities of the federal government.”
Right. In this case, as long as the CB remains solvent, it can maintain price stability no matter what. People wouldn’t flee from government bonds into real assets, they would flee from government bonds into money. This is of course what has happened in the euro zone.
If AD is increasing too fast, whatever else is true, you are no longer in a depression. The idea that it is possible to overshoot on a correction mechanism is no reason to absolutely reject that mechanism.
Nick,
I think the whole bond vigilante idea is a major cause of confusion. As you said, long term bonds are an unnecessary complication. So just think of t-bills. t-bills trade at the policy rate for straightforward arbitrage reasons. The policy rate is driven by a Taylor rule. So there are no bond vigilantes, neither in this model nor in the real world. Nominal rates rise when NGDP expectations rise as a direct consequence of some kind of forward looking Taylor type rule.
So the “bond vigilante attack” is exactly according to the equations that constitute our monetary policy. Nothing mysterious, nothing to fear.
The only question is, can our policy rule control inflation even in the face of high government debt? I don’t see why not. What is it about high debt levels that makes demand less responsive to rate hikes?
@nick:aha! exactly what i thought. you’re working with a natural rate of interest. I think in this context your thesis makes no sense. If you look at treasury yields, you’ll see they are dominated by the target interest rate. If interest payments are driving inflation, a central bank that raised interest rates to slow inflation would be moronic. I understand how you get there ala wicksell, but i don’t think that actually makes sense.
Nick, :
I find it in incredible that when both Canada and the United States are suffering a chronic lack of AD, you worry about too much AD. Who cares about a little inflation, the depression is worse.
Further to Nathan Tankus’ point, in any real control system, you have and must have some degree of overshoot. A fairly realistic model (proportional/integral/derivative, second order differential) must have more overshoot the faster it works (gets to target first time). Then the system bounces around to settle down.
You argue that the Central Bank, which is exogenous here, its actions with regards to interest rates can be easily controlled, cannot restrain itself and will be overenthusiastic in stamping out a boom. What, central bankers can’t be lazy and slothful? When the time calls for just that? We can’t get Mark Carney drunk or stoned for a few months?
If the debt were small, the amount by which taxes would need to be raised and/or spending cut to cover the increased debt service costs would be small too, and it could easily be done. But if the debt were large, the amount by which taxes would need to be raised and/or spending cut to cover the increased debt service costs would be large too, and it could not easily be done.
This is one those statements about government debt financing that you put in these posts that contains more than one fallacy, IMO. It implies a static view of an economy, that an economy cannot outgrow its debt burden. That is exactly what the US and Canada did to our war debts. Tax rates remained static throughout the post-war period, in fact if anything they went down slightly, yet actual debt was never paid off in nominal terms. It was just paid off by out-growing it.
Your posts about taxes also posit that a government cannot borrow indefinitely from the private sector. As the UK’s public debt is 300 years old, the US is 225 years old and Canada’s has been around permanently since 1867, that supposition is wrong. With growth, which implies a multiplier greater than one, it is an open question whether debt is a burden. Most of the time it is not, as the interest rate on government debt is below the growth an inflation rate. Government debt is permanently ponzi-ish because the private sector allows it to be so.
Paul Krugman has repeatedly said, with good evidence, that the upper borrowing limit for a sovereign with its own central bank and currency is at least at 200 – 250%. The US ended WWII with a debt/GDP ratio of 120% and that was followed by the Post-war Boom. The UK government was a 200%+ and it still had decent economic performance. Japan is still not in trouble with a 200% ratio, so why we are worrying about the US is beyond me.
BTW if the bond vigilantes want to have a party in Canada, I’d be overjoyed. Throw them a party at the Bank of Canada, get them so drunk and stuff them with food they’d never want to leave. 🙂
The policy rate is driven by a Taylor rule. So there are no bond vigilantes, neither in this model nor in the real world.
Simple, clear and logical. I’m with K.
Nick, if you really believe there are such creatures as “vigilantes” you should make a general equilibrium case for that.
First, you need to throw away full Ricardian equivalence (otherwise the vigilantes would not care).
Second, assume a sudden change in preferences for less savings, causing everyone to go on a consumption binge as they attempt to sell their bonds and buy goods, even though the average family has less savings now than it did 10 years ago, and increased income uncertainty.
Third, assume that the central bank responds to this by hiking interest rates rather than tolerating an elevated level of inflation (which would reduce government debt). But even now, CBs all around the world are promising elevated inflation during the recovery.
Fourth, assume that the government is not receiving anymore revenue in response to the increased consumption binge, together with decreasing the benefit payments going out, allowing it to pay higher interest rates if necessary.
You have not painted a coherent picture of something that is likely to happen or that we should be afraid of if it does.
It seems to me that countries like Canada or the US can only be successfully attacked by bond vigilantes if its central banks joins in the attack, and if its government then passively accepts the joint attack and doesn’t take legislative steps against it. In other words, these governments have to attack themselves.
Which is silly when the Government owns the Bank of Canada, has a memorandum of agreement about policy and in a
zombiebond vigilante attack could issue a directive to the Bank of Canada to defend the CAD$, or buy a mountain of bonds, or whatever. It helps that the Bank of Canada is across the street and down a block from Parliament Hill so the Finance Ministercan punch the light out ofhave a vigorous policy discussion with the Bank of Canada Governor whenever he wants.Why havent they attacked already? You mean to tell me they have been happy with near 1% rate the last 4+ years? If there was any group actually able to demand higher rates, in the face of a fed committed to keeping the rates it controls low, we would have already seen them. We wont see higher rates til the fed says so.
The bond vigilantes are frolicking and doing blow with the confidence fairies.
Gizzard, I don’t think Nick is saying they’ll force higher rates. He’s going along with Krugman and saying an “attack” will manifest through exchange rate depreciation.
wh10: He’s going along with Krugman and saying an “attack” will manifest through exchange rate depreciation
Hm. How do you attack a floating exchange rate? I mean attack permanently. Floating exchange rate is a consequence, not a reason.
BoJ has been attacking exchange rate for ages and despite its unlimited firepower those “vigilantes” seem not to care and keep on pushing.
Simon:
“I think that the problem with the Krugman analysis is that he has one interest rate.”
It goes beyond that. The problem with the Krugman analysis is that it does not distinguish between accrual debt that the federal government sells, amortization debt that the private sector engages in, and coupon debt that the federal government used to sell.
The only way that interest rates “control inflation” is by making a transfer from positive cash flow to positive balance sheet. Meaning that by buying long term accrual government bonds a person is willing to forgo positive income for positive net worth.
Picture a federal government that only sold coupon bonds and a private sector that had an excess of aggregate demand.
Question: How would higher interest rates lower aggregate demand?
Answer: They would not, in fact they could make it worse. A rise in interest rates would mean an increase in coupon payments by the federal government.
Nathan,
“That is exactly what the US and Canada did to our war debts.”
WRONG. Here is a chart comparing total US debt (public and private) to US nominal economic growth:
http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=GDP_TCMDO&transformation=lin_lin&scale=Left&range=Custom&cosd=1950-01-01&coed=2012-07-01&line_color=%230000ff&link_values=&mark_type=NONE&mw=4&line_style=Solid&lw=1&vintage_date=2012-11-11_2012-11-11&revision_date=2012-11-11_2012-11-11&mma=0&nd=_&ost=&oet=&fml=a%2Fb&fq=Quarterly&fam=avg&fgst=lin
The war debt was not reduced by growth. It was replaced with private debt. There are only two ways to reduce debt. You either collect more in income than you spend – which is impossible for everyone to do in a capitalist system. Or you convert debt to equity.
Frank: “There are only two ways to reduce debt. You either collect more in income than you spend – which is impossible for everyone to do in a capitalist system. Or you convert debt to equity.”
Is this what you learned from MMT??? No, no, no! If this year I spend $100 more than my income, and you spend $100 less than your income, and lend me $100, then debt rises by $100. Next year I spend $105 less than my income, you spend $105 more than your income, as I repay my loan and interest, then debt falls by $105.
But that is totally off-topic.
I read the comments, then despaired, and went and changed the oil and filter on the MX6. rsj is sort of maybe getting it (though writing down the equations of a model and solving it is a lot easier said than done). But the rest seem to be totally misunderstanding my post. Now clearly that’s maybe at least partly my fault, for not explaining myself clearly enough. Or maybe it’s just a hard topic to explain clearly. Or maybe you’re all coming from some totally different MMT-space. (Dear old Winterspeak totally missed my point as well).
Aggregate Demand depends (negatively) on: the rate of interest; the willingness of people to hold the existing stock of government bonds at a given rate of interest rather than sell them for money and then use the money to buy real goods.
AD is too low in the US right now. The US needs (say) a 5% increase in AD. But you don’t want AD to increase more than that. There is an AS curve out there somewhere! We don’t want an infinitely large increase in AD.
If people became less willing to hold US bonds, that would increase AD. But if it increased AD by too much, the Fed would have to raise interest rates to stop AD increasing too much. If people became a lot less willing to hold bonds, the Fed would have to increase interest rates a lot.
I think I will now wash the MX6.
If people became less willing to hold US bonds, that would increase AD. But if it increased AD by too much, the Fed would have to raise interest rates to stop AD increasing too much. If people became a lot less willing to hold bonds, the Fed would have to increase interest rates a lot.
Overshoot is bound to happen in any realistic system with inefficiencies, constraints and storage dynamics. Tell the Bank of Canada Governor to take up pot smoking while this recovery is taking place, so he doesn’t get all antsy about inflation.
The faster the rise time (from initial condition to target), the greater the overshoot. That’s math.
Why are you seeing inflation under every bed, Nick? Real work requires the worker to get his hands dirty, so a little inflation is no bad thing.
Nick,
First, worrying about excessively high AD is like shouting fire in Noah’s flood.
Second, if there was a sudden and dramatic shift for less risk free savings — something that in the history of the earth has never occurred — all that the CB would need to do would be to raise rates by a small amount, not by a large amount.
This is because of duration. Right now, rates are extremely low — yield on a 10 year bond is 1.6%. Suppose all government bonds were 10 years. Suppose there was a sudden demand to decrease holdings of government bonds by 10%. How much would the CB need to raise rates to accomplish this? About 1.2%.
In a low interest rate environment, the CB would only need to raise rates by a very small amount in order to accomplish a large reduction in savings. That is why Japan has been stuck at zero rates for about 20 years now. If this was really an “unstable” system, we would have seen it. But when you have long lived assets in a low rate environment, very small changes in rates correspond to large reduction in savings.
I don’t think you are looking at this properly and I don’t think you have a convincing model.
But again, it’s all shouting fire in Noah’s flood.
A better metaphor: I’m saying we need to fix the leak in the reservoir as soon as possible, because when the flood is over we won’t have enough water left for the dry season.
Nick,
“There are only two ways to reduce debt. You either collect more in income than you spend – which is impossible for everyone to do at the same time in a capitalist system. Or you convert debt to equity.”
I typed too fast – missed the “at the same time” part. I think we can agree that simultaneous surpluses are impossible.
“Is this what you learned from MMT??? No, no, no! If this year I spend $100 more than my income, and you spend $100 less than your income, and lend me $100, then debt rises by $100. Next year I spend $105 less than my income, you spend $105 more than your income, as I repay my loan and interest, then debt falls by $105.”
Again I missed the “at the same time” part. Sorry for the confusion. As for MMT, it has a lot to offer in terms of economic theory, but even it does not consider the possibility of government equity. MMT explains the federal government’s lack of bankruptcy risk (government bonds denominated in government currency) but it misses a few components – the yield curve matters and the difference between public and private debt (amortization versus accrual) matters.
You said: “A large attack by the bond vigilantes would be a bad thing, because it would increase Aggregate Demand too much. That would force the Fed to increase interest rates a lot, and that would force the US government to raise taxes and/or cut spending to cover the increased costs of servicing the debt.”
A large attack by the bond vigilantes would neither be a “good” or “bad” thing. Apparently you believe that economics is some sort of morality play with good guys and bad guys. It wouldn’t force the US government to do anything. To accomodate the increase in the cost of servicing its debt the federal government could chose to either increase revenue, cut spending, increase the duration of its debt, or sell equity instead of debt.
You said: “The longer the US stays in recession, with a large budget deficit, the bigger the debt will grow.”
The longer economists and economic advisers keep their models limited to a Hicksian three good economy (money, bonds, and commodity goods), the bigger the total debt (private + public) will grow.
When water is gushing over the top of the reservoir dam, a leak is the least of your worries.
You cannot simultaneously try to fight inadequate AD and some imagined, theoretical inflation crisis. First things first.
Why exactly do we need to invent non-existent problems when our actual problems are more than troublesome enough?
Aggregate Demand depends (negatively) on: the rate of interest; the willingness of people to hold the existing stock of government bonds at a given rate of interest rather than sell them for money and then use the money to buy real goods.
I don’t get it. If one guy sells his bonds for more money, then he has fewer bonds and more money; but some other guys has more bonds and less money. How did this increase aggregate demand?
Dan Kervick,
“I don’t get it. If one guy sells his bonds for more money, then he has fewer bonds and more money; but some other guys has more bonds and less money. How did this increase aggregate demand?”
Great question. For that you have to understand the yield curve and the nature of government debt. The correlation between aggregate demand and short term interest rates is positive, not negative. The correlation between long term interest rates and aggregate demand is negative. And so what Paul Krugman and Nick Rowe are really asking for is an inverted yield curve. Low long term rates (to discourage saving) and high short term rates (to increase income and aggregate demand).
Dan: suppose there were a rush to get out of bonds to hold money instead. No problem. The central bank just takes the other side of the trade, and buys the bonds (unless we are talking about Greece, of course). But if there were a rush to get out of bonds and into real goods, via money, then a little bit of that is a good thing, but too much of that increases demand for real goods too much. They sell the bonds for money, because everything gets sold for money, but they don’t want to hold the money, they want to spend it.