Now That Debt Crisis Can’t Be Blamed on Tea Party, Krugman Back to Saying It’s Expansionary
[UPDATE below.]
Sometimes the cognitive dissonance in Krugman’s mind could power a small city. As regular readers know, I was going nuts during the debt ceiling standoff, because Krugman was parroting the standard talking points as if a default would be a disaster. For example he wrote on September 25:
Add me to the chorus of those puzzled by the lack of market alarm over the possibility of U.S. default, induced by failure to raise the debt ceiling….[I]f most political reporters are still in denial over the real state of affairs, one can imagine that businesspeople are having an even harder time realizing the extent to which the inmates have taken over the asylum.
But suppose that markets were giving the possibility of default the attention it deserves; how should they be reacting? That’s not actually all that obvious, at least as far as interest rates are concerned.
…So I’m not at all sure that we’re looking at an interest rate spike; maybe even the opposite.
But for sure we should be looking at a plunging dollar, and probably carnage in the stock market too. [Bold added.]
Now the thing that was interesting, was that in the part I omitted, Krugman walks through his analysis that the Fed could sop up the bonds that investors no longer want to hold, thus pinning short-term interest rates down. In short, he gives the exact same analysis that he had deployed earlier, to explain why an attack by the bond vigilantes on the US would actually be expansionary.
So the thing that troubled me, was that Krugman never devoted a single sentence during the debt ceiling standoff to this “silver lining.” He never said, for example, “Sure, it will be bad if the feds have to slash spending, but at least we’ll get the expansionary kick from a plunging dollar and a higher nominal natural interest rate.” This wasn’t just my nitpicking; Tyler Cowen picked up the discrepancy too.
Now, literally the day after the crisis is formally averted, Krugman is back to his old line. He writes:
Matthew Yglesias notes an uptick in Very Serious People warning that China might lose confidence in America and start dumping our bonds. He focuses on China’s motives, which is useful. But the crucial point, which he touches on only briefly at the end, is that whatever China’s motives, the Chinese wouldn’t hurt us if they dumped our bonds — in fact, it would probably be good for America.
But, you say, wouldn’t China selling our bonds send interest rates up and depress the U.S. economy? I’ve been writing about this issue a lot in various guises, and have yet to see any coherent explanation of how it’s supposed to work.
Think about it: China selling our bonds wouldn’t drive up short-term interest rates, which are set by the Fed. It’s not clear why it would drive up long-term rates, either, since these mainly reflect expected short-term rates. And even if Chinese sales somehow put a squeeze on longer maturities, the Fed could just engage in more quantitative easing and buy those bonds up.
It’s true that China could, possibly, depress the value of the dollar. But that would be good for America!
…
The persistence of scaremongering about Chinese confidence is a remarkable thing: it continues to be what Very Serious People say, even though it literally makes no sense at all. As Dean Baker once put it, China has an empty water pistol pointed at our head. [Bold added.]
Now let’s see: In the last month, who has been engaged in scaremongering about the world credit markets not having confidence in U.S. government bonds? Who was warning people that the market was underrating the risk of a plunging dollar?
If Will Ferrell were an economist, I think at this point he’d ask, “Doesn’t anyone notice this?!”
UPDATE: Wow, this is a worse Kontradiction that I at first realized. If you actually click through to read Yglesias’ discussion–which prompted Krugman’s post above–then you’ll see that Yglesias specifically was placing his remarks in the context of the debt ceiling standoff. In other words, Yglesias was saying (my paraphrase), “The worry warts about China dumping our bonds are really in high gear now, because of the debt ceiling shenanigans. But they fail to see that if those shenanigans had made China dump our bonds, it wouldn’t have hurt us.” Then Krugman, in response to Yglesias, was saying (my paraphrase), “Right, but Matt isn’t taking it far enough. As I’ve been saying for a long time now, if China dumped our bonds, that would if anything help our economy because a falling dollar would boost net exports.”
So I hope you realize just how nutty this is, when Krugman a mere three weeks earlier had warned that the idiot Tea Party Republicans were going to possibly cause a debt default, which would lead to a plunging dollar and carnage in the stock market.
It matters why the upward pressure on U.S. rates occurs. If the upward pressure on rates occurs, because the U.S. debt actually gets riskier and actually has higher default rates, that has a different effect than if there is an upward pressure on rates, because one demander leaves the market for idiosyncratic reasons.
Think about the following example for a BBB rated company.
A) News about the future of the firm is very negative and it’s credit rating a risk profile fall to C.
B) Congress passes a law that says pension funds can’t hold BBB debt.
If financial markets are perfectly efficient, B won’t matter at all. Innovative investment banks can just carve up the risk and sell it off. Obviously, scenario A will always raise the firm’s cost of borrowing.
If the dollar plummets, because RGDP is expected to be permanently lower, it will have a different effect than if the dollar plummets, because the expected inflation rate will be higher. Implicitly, the good scenario assumes the Fed would like to be more expansionary, but can’t (bc of the zero lower bound). Possibly that isn’t true, but it is an inconsistency.
This doesn’t make sense. We’re taking the upward pressure of rates as a given in both scenarios, right? And then you allude to some other mysterious “effect” of A’s higher rate versus B’s higher rate.
For simplicity, let’s talk zero-coupon bonds, where the higher rate is reflected in the below-par bond price.
So, for Bob’s Breakfast Burritos, a BBB rated company, we have 2 scenarios where the bond price drops:
A) lower demand for a riskier investment (risk premia, etc.)
B) lower demand because willing buyers are prevented by law from buying
You say:
> If financial markets are perfectly efficient, B won’t matter at all. Innovative investment banks can just carve up the risk and sell it off. Obviously, scenario A will always raise the firm’s cost of borrowing.
I submit that both cases raise the firm’s cost of borrowing. I’m still not sure what other effect you are referring to.
In B the market price of the firm’s risk hasn’t changed. Upperward pressure on the firm’s interest rates is just the partial equilibrium effect. Savvy hedge funds and mutual funds buy the underpriced debt. Investment banks securitize the debt so parts are AAA and parts are DDD. Then sell the AAA debt to pension funds.
Since the firm’s actual risk hasn’t changed, any rise in rates is a disequilibrium. There is a free lunch, until new buyers raise the price of the firm’s debt. Thus, it is quite dangerous to stop t elling an asset pricing story after a quick partial equilibrium supply in demand.
That’s much clearer, thanks.
So with A, the product has changed, which reduces the demand for it.
With B, the product is the same, but the artificial demand constriction lowers the price of new bond issues, and at this lower price, this opens up more demand.
I’m still not sure that China is an example of B moreso than a leading indicator of A.
“I’m still not sure that China is an example of B moreso than a leading indicator of A.”
A reasonable position, but not Krugman’s, and this Murphy post argues not that Krugman is wrong, but that he is logically inconsistent. My point is just that his views are reconcilable.
Dare I say, “never reason from an interest rate change?”
So, if the President and Paul K whine about the GOP causing a default that never happens, that changes the real value of US debt.
But if China as a real investor in US debt decides to really avoid investing in it, that is the irrational action of an idiosyncratic entity, and has no bearing on the value of the debt.
What if 90% of investors decide to be idiosyncratic?
Charlie,
I understand where you’re coming from, and in general yes, the reasons for a particular change matter, but not in terms of Krugman’s arguments. He specifically writes:
“He focuses on China’s motives, which is useful. But the crucial point, which he touches on only briefly at the end, is that whatever China’s motives, the Chinese wouldn’t hurt us if they dumped our bonds…”
In either case, the dollar is plummeting for similar reasons–foreign investors are no longer as eager to hold US dollars because they fear default. If you click the link, you’ll see Yglesias was specifically referring to the recent debt ceiling crisis, so Krugman in context is presumably arguing that the debt ceiling crisis would have helped the US had foreigners dumped US bonds. So the Kontradiction is even more striking than I originally realized (because I hadn’t clicked through to Yglesias).
Bob,
” whatever China’s motives, the Chinese wouldn’t hurt us if they dumped our bonds”
There is a real probability of default that Chinese feelings are motives about default can’t change, just as there is a real probability IBM exceeds earnings next quarter that my thoughts about IBM don’t change, and just as there is a real expected inflation rate that Bob Murphy’s thoughts about inflation (thankfully) doesn’t change.
The Chinese don’t change anything about the fundamentals of U.S. debt if they choose to diversify into other debt.
But let’s think about the corollary, suppose the tea party drives the real probability of default risk much higher. Does it prevent problems for the U.S. if China decides to stick with us and not sell it’s U.S. debt? No, all the other market participants can sell there debt. The price can move just as much without China making a single trade. Thus, China’s reaction in either good times or bad is basically irrelevant. What could have an effect is a change in the real risk of default, but if that happens, China’s response is meaningless.
Lastly, I went back and read some of the posts of Krugman on the debt crisis, and one of the main concerns he has is the fiscal consolidation. He seems somewhat agnostic that there would be a financial crisis (though he thinks the risk of that event would go up). Obviously, this is another difference in the two scenarios, since China should have no effect on U.S. fiscal policy.
Here are examples:
http://krugman.blogs.nytimes.com/2013/10/08/default-deniers/
” I think the administration has made a tactical error by putting all the weight of its warnings on the financial consequences; we might have a Lehman-type event, but we might not…What sane people should be emphasizing is that in addition to the risk of financial disruption, there’s the certainty of huge pain from spending cuts and a crippling hit to economic growth.”
http://krugman.blogs.nytimes.com/2013/09/25/default-notes/
“But suppose that markets were giving the possibility of default the attention it deserves; how should they be reacting? That’s not actually all that obvious, at least as far as interest rates are concerned…If the feds are forced to slash spending, one way or another (and probably semi-randomly) to match receipts, that’s about $600 billion in cuts at an annual rate, or 4 percent of GDP. That’s a huge case of unintended austerity, quite aside from the disruptions, surely enough to push us back into recession if it lasts for any length of time.”
US debt isn’t worth what investors are willing to pay for it; it’s worth whatever Paul Krugman thinks they ought to be willing to pay for it.
You can use cognitive dissonance to generate political power.
Sadly, not electrical power.
Attacks from bond vigilantes is only good if the cause is something other than Republican/Conservative/GOP scheming.
If the cause is Republican/Conservative/GOP scheming, then the bond vigilantes are destroying America.
This is the case even if the effects are the exact same.
BMurphy wrote: “Sometimes the cognitive dissonance in Krugman’s mind could power a small city.”
Rather than a power, I think of it as black hole with nothing but destructive forces…
Paul Krugman on the Debt: Why He Can’t Be Taken Seriously
http://www.jeremyrhammond.com/2013/10/19/paul-krugman-on-the-debt-why-he-cant-be-taken-seriously/
No comment necessary. Krugman hangs himself in quotes.
Would it be silly to say the markets ignored, as far as bonds and interest rates, what Obama and Congress do because they factor in the FED will simply mop up whatever bonds are dumped on the market, just as Krugman says? What option does a dollar denominated bond holder have but to accept dollars in payment for his holdings if he wanted to sell? Yes, I understand at some point there WILL be consequences but we all think we’ll know how to time the market don’t we?
At some point there will be a showdown between the Fed and the Treasury over interest rates. The Treasury wants unlimited borrowing (primarily for itself) at low interest rates and no constraint on spending. If the Fed allows interest rates to rise (which they certainly would if QE ever stops) the Treasury will suddenly find a widening chunk of expenditure going into interest payments… probably a rapidly widening chunk.
That’s the day when push comes to shove and we figure out who is driving the bus.
If the Fed knuckles under and allows inflation and continuous low interest rates, then it destroys any chance of an exit strategy. Maybe that doesn’t matter because the money came from nowhere to begin with, but the effective loss will be staggering.
Paul Ormerod points out why government bonds rated as “low risk” can still be very risky:
http://www.paulormerod.com/everything-is-crystal-clear-with-hindsight/