I recently pointed out that Krugman’s September 25 commentary on the possibility of a US government default was at odds with his pooh-poohing of a debt crisis caused by bond vigilantes. I don’t think people really saw just how badly Krugman had painted himself into a corner, so I had planned on doing a mock “Krugman” post where I used his standard diagrammatic framework to show that right now, the full-employment nominal interest is negative, meaning we’re stuck in a liquidity trap recession. If the fear of a government default makes investors less willing to hold Treasuries, then the full-employment nominal interest rate rises and eventually goes positive, meaning the Fed can finally fix the economy using conventional monetary policy. Whew!
Well, I don’t really need to do any of this, because Krugman on October 3, in a post titled, “Phantom Crises (Wonkish),” does my work for me. Here are some excerpts:
…a loss of investor confidence driving up interest rates and plunging the economy into a deep slump.
As I’ve written before, I just don’t see how this is supposed to happen in a country with its own currency that doesn’t have a lot of foreign currency debt – especially if the country is currently in a liquidity trap, with monetary policy constrained by the zero lower bound on interest rates. You would think, given how many warnings have been issued about this possibility, that someone would have written down a simple model of the mechanics, but I have yet to see anything of the sort.
Let’s start with something like a canonical model – a model in which there’s an IS curve representing the effects of interest rates on demand, and monetary policy is described by some kind of Taylor rule. David Romer calls this the IS-MP model, and it looks something like this at a given point of time…
[KRUGMAN HAS A DIAGRAM.]
Now suppose that investors turn on your country for some reason. This can be represented as a decline in capital inflows at any given interest rate, so that the currency depreciates….
My point is that what sounds like a straightforward claim – that loss of foreign confidence causes a contractionary rise in interest rates – just doesn’t come out of anything like a standard model. If you want to claim that it will happen nonetheless, show me the model!
Furthermore, as Wren-Lewis says, even if there is somehow a squeeze on long-term bonds, why can’t the central bank just buy them up? Yes, this is “printing money” – but when you’re in a liquidity trap, that doesn’t matter…
I know that many people find this line of argument, in which a loss of investor confidence is if anything expansionary, deeply counterintuitive. But macro, and especially liquidity trap macro, tends to be like that. So don’t give me your gut feelings; give me a coherent story about who does what, i.e. a model. I eagerly await a response.
Now in fairness, Krugman (of course) isn’t talking about the US and the possibility of a default in the above. Rather, he’s talking about Great Britain and why they don’t need to implement “austerity,” even if we thought investors would turn on them.
But the logic is the same. I put the crucial sentence in bold in the above. There’s nothing in Krugman’s argument that means a loss of confidence because of obstinate Republicans is different from a loss of confidence because of profligate Democrats.
At BEST, Krugman should be saying the following:
==> ON ROGOFF-TYPE FEARS: “Well, the drop in investor confidence would be expansionary. However, to the extent that the attack of the bond vigilantes made it harder to borrow money, the government might have to cut spending, and that would be bad. So we’d have to assess which force would be stronger, and I predict the former would outweigh the latter, meaning the economy would be helped on net.”
==> ON BOEHNER ET AL.: “Well, if the government can’t borrow more money, obviously there will be an immediate slash in spending, which will be awful for the economy. However, the silver lining is that the crash in the bond markets will actually be expansionary and promote exports. So that will cushion the blow. I predict the former would outweigh the latter, meaning the economy would be hurt on net.”
Yet Krugman never did anything like the above. Nope, when it comes to people recommending “austerity” to quell the possibility of a bond vigilante attack, Krugman says it would be expansionary, end of story. Then, when it comes to the Republicans and the debt fight, Krugman says: “But for sure we should be looking at a plunging dollar, and probably carnage in the stock market too.”
Now in context there, 99% of Krugman’s readers are going to think a “plunging dollar” is a horrible consequence of those rascally Republicans. And yet, Krugman elsewhere argues that a plunging dollar is great to promote exports.