You may recall that Krugman recently argued that an attack by the “invisible bond vigilantes” (the opposite of the confidence fairy, for those keeping track) would actually be good for the US economy, because it would weaken the USD and thus boost Aggregate Demand. I pointed out the problem with in normal English here. But Nick Rowe has done the same thing within the standard New Keynesian paradigm:
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.
To his credit, Brad DeLong acknowledges that Nick Rowe has a point. But don’t worry, DeLong has a solution:
There is, I think, one thing he misses. Demand for U.S. Treasuries is a function not just of bond market confidence but also of the regulatory structure. The government can regulate to boost the demand for cash and Treasuries: high capital requirements for financial institutions are a very effective way of cooling-off aggregate demand and reducing the burden of servicing the U.S. debt. And capital requirements can, if the government wishes, be made very high indeed… [Ellipsis in original.]
And there you have it! We don’t need to worry about deficits causing investors to lose faith in US government bonds. If they stopped buying it, why the government could just force American institutions to hold the toxic assets. Keynesianism For the Win.