Consulting by RPM || Free Advice Blog

Resolving (Sort of) Krugman on Bond Vigilantes and Debt Default

OK so for the last month or so I’ve been asking: How can Paul Krugman have been arguing repeatedly that an attack by the “bond vigilantes” (because they’re worried about high levels of a government’s debt) be “expansionary” and hence good for an economy currently stuck in a liquidity trap, while at the same time Krugman says there will be “carnage” in the stock market and a likely double dip recession if the US Treasury defaults on its debt?

Daniel Kuehn pointed me to a definitive Krugman post on this issue that I either missed or forgot about, which Krugman wrote back in July 2011. In that post, Krugman had been responding to Nick Rowe, who in turn had written a post asking, “Do Keynesians believe their own models?” So seeing all this, reassured me I was on the right track: Nick Rowe too saw that today’s Keynesians (and Nick included himself in this group as a “quasi-Keynesian”) were using models that implied a debt default would, if anything, be expansionary. [UPDATE: Brad DeLong and Scott Sumner contribute in the comments of Nick’s post, and everybody ends up settling on a particular assumption that makes default either expansionary or contractionary.]

Anyway, Krugman did not agree with Nick, but Krugman agreed it was subtle–it was a “(Very Wonkish)” post to walk through this terrain. Here’s a key paragraph from Krugman, explaining why inflation (which weakens bonds and yet Keynesians love) is good but default risk (which also weakens bonds) is not:

It’s true that, say, a 1 percent possibility that your bond holdings will become worthless within a year is similar to the expectation that inflation will erode those bonds’ real value by 1 percent over the next year. But inflation doesn’t just erode the value of bonds; it also erodes the value of cash. And that’s why expected inflation can help in a liquidity trap: it makes sitting on cash less attractive. The threat of default doesn’t do that. As far as I know, we’re not talking about a loss of confidence in pieces of paper bearing pictures of dead presidents. And that’s why the threat of default isn’t equivalent — and not expansionary.

OK, fair enough, but now I can point out the specific contradiction, or if we’re generous, the specific modeling assumption that Krugman changes when he’s talking about fears of Democratic profligacy versus fears of Republican obstinancy: In the former case, Krugman invokes foreign investors and how their reduced willingness to hold US (or UK, or Japanese) bonds will depreciate the currency and thus boost net exports. Here’s a key excerpt from Krugman’s essay on bond vigilantes from November 2012:

Now ask, what happens if there’s a loss of confidence, causing the risk premium ρ [on US government bonds] to rise? The answer is that the currency depreciates for any given domestic interest rate, increasing demand and shifting the IS curve out. That is, the effect on the economy is expansionary.

Think about it this way: with the Fed setting interest rates, any loss of confidence in U.S. bonds would cause not a rise in rates but a fall in the dollar – and a fall in the dollar would be a good thing, helping make US industry more competitive. [Emphasis in original.]

So to sum up: As best I can tell, when Krugman wants to explain why a debt default caused by Republicans is bad, he says it’s because people will dump bonds but still embrace the currency. When Krugman wants to explain why an attack by bond vigilantes caused by Democrats is good, he says it’s because you can’t dump US bonds without depreciating the currency at the same time.

Yes, I’m being a tiny bit flip with the Republican/Democrat labels, but that was only for brevity. If you replace Republican with “people who want the government to spend less than Krugman wants” and Democrats with “people who want the government to increase spending like Krugman wants,” then it’s not only a fit for past observations but also would be a good predictive model of future Krugman posts.