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 
K: suppose people decide they want to hold a smaller stock of bonds than they currently hold. Either the rate of interest rises enough to persuade them to keep holding the bonds, or the central bank buys the bonds for money to prevent the rate of interest rate rising. If the people are willing to hold more money and less bonds (so their desired stock of M+B is unchanged, but they just wanted more M and less B) then nothing happens. But if (as is more likely) that don’t want to hold more M and less B, they will spend that extra M they don’t want to hold. That increases AD. If it increases AD only a smallish amount, that is good. if it increases AD a largish amount, that causes too much demand for goods and too much inflation.
Unless you believe in Ricardian Equivalence, the stock of bonds people are willing to hold is a positive function of the rate of interest on those bonds. So a larger stock of bonds will require a higher rate of interest for them to be willingly held, other things equal. Take one of my OLG models, for instance. Each period the young save to buy the bonds from the old. The amount they are willing to save and postpone consumption is a positive function of the rate of interest.
I’m not putting forward any wild new theories here.
Bob: Thanks! I like your post too! But a total strike by bond buyers, at any rate of interest, is a bit too extreme an example. More likely is that they won’t buy except at a higher rate of interest.
“One of these days you’re going to realize you need to stay stuff like, “Printing up more $100 bills is good within limits,” or “Investors attacking our bonds is good within limits.””
I much prefer it without the “DON’T”!
Nick,
Unless you are a believer in “bond illusion”, there is no such thing as a demand for bonds, there is a demand for savings. As the interest rate goes up, savings decreases sharply, because the re-sale value of the asset falls.
This is particularly true for land and equity, which are the primary means of savings for most people, and in terms of market value, far eclipse the quantity of bonds. The vast majority assets cannot be held to term and must always be re-sold.
In that case, an increase in the rate of interest, particularly in a low rate environment, leads to a massive and sudden decrease in savings.
rsj: “As the interest rate goes up, savings decreases sharply, because the re-sale value of the asset falls.” You need to distinguish between the supply and the demand for a stock of assets. If you measure that stock in terms of its value, then a rise in r means a fall in the value of the stock supplied. But the result is the same. A fall in demand for the stock means that r must fall to re-equilibrate supply and demand.
And “desired saving” in normal economic language, is a demand for a flow of non-consumption goods.
K,
“What is it that suddenly makes bond holders feel the real rate is too low and they now want to invest/consume more?”
I think you need to break that question into two parts:
What is it that suddenly makes bond holders feel that the rate of return they are receiving is too low and then now want to invest in an asset that has a higher potential rate of return?
Part of the answer to that question is market access. Part of the answer to that question is risk / reward.
What is it that suddenly makes bond holders feel that the rate of return they are receiving is too low and they want to consume more?
Kind of a trick question if you believe that people make consumption decisions based upon net worth (anticipated future income) rather than current income. And so reducing that rate of return may have the opposite intended effect.
And finally, their are buyers of federal debt that do not buy it based on its rate of return. They buy it because they are legally obligated to (primary dealers), they buy it to maintain a positive balance of trade, or they buy it to maintain a policy rate of interest (federal reserve).
Bob Murphy,
“a bond attack is bad, period.”
Not if it occurs when either the federal debt is falling or the average duration of the federal debt is rising.
“But if (as is more likely) that don’t want to hold more M and less B, they will spend that extra M they don’t want to hold.”
Then they aren’t really bond vigilantes, but rather money vigilantes that happen to own bonds.
You haven’t made it clear (or I haven’t understood) why you think that bond/money vigilantes will emerge. Is it because the government (and with it the central bank) becomes insolvent?
Max: “You haven’t made it clear (or I haven’t understood) why you think that bond/money vigilantes will emerge.”
You understood me OK. I didn’t try to explain that. Like Paul Krugman, I just assumed they did emerge, and asked what the consequences would be. Scott Sumner thinks we shouldn’t reason from a risk premium, and need to explain why it rises. I’m collecting my thoughts on that question, for maybe a future post.
This comment was emailed to me by “CdnExpat” (for some reason it didn’t appear):
The model under discussion [PK’s] is not up to the task at hand. It models a
bond market run as a simple exchange rate shock, ignoring the consequences on
financial wealth, risk premia in markets other than the foreign exchange
market and aggregate supply. An implication of the model, if it is taken
seriously is that the US should invite bond market vigilantes to the
door with open arms. Now really, does that seem the slightest bit plausible?
Also it is a (very) small open economy model which means that the
domestic interest rate is pinned down by foreign conditions and so the bond
market run manifests solely in a depreciation. In truth, what would happen is
some combination of higher (domestic) interest rates and a lower exchange
value of the dollar; output could rise or fall (probably the latter but it
isn’t clear) but even if production rises consumption has to fall. Welfare is
reduced as Americans would be obliged to work more to pay the claims of
foreign creditors rather than fund consumption.
The above is by CdnExpat.
As I understand it, a bond vigilante is just someone who wants to sell their bonds. Hasn’t the Fed been doing its best to convince people to sell them their bonds? In other words, they already welcome bond market vigilantes with open arms.
K,
“Yes, they can choose to just give 36% extra to the bond holders, rather than spending it on valuable projects or cutting taxes.”
Valuable projects like – two wars? As for cutting taxes, a government could keep playing the give away take way game with tax rates, or they could sell permanent tax breaks that have a non-guaranteed rate of return.
Have to admit that I’ve never heard of bond vigilantes and prospect of attack on the USD. Still unclear as to threat but a
lively debate
to be sure.
Non-related blog