Shackling the Bond Vigilantes
In a world where pundits divide into those who think the federal government should be doing more to help the economy, and those who think it’s already done (way) too much, economist and New York Times columnist Paul Krugman lands squarely in the former camp.
In fact, you might say that he is the de facto spokesman for the former camp.
His two-fold argument, in a nutshell:
One. Deficits matter, but primarily in the long run; in the short run, righting the economy and bringing down unemployment matter most; and
Two. The credit markets will signal when the federal debt is reaching dangerous levels (and the government must curtail its spending). Instead of rising rates, however, record-low interest rates indicate that everything is hunky-dory.
In fact, given how cheaply the U.S. government can borrow at the moment, Krugman argues that the federal government should be doing a lot more of it now.
Call the foregoing the “anti-austerity case.”
Fly in the Ointment
The catch, of course, is that the credit markets are not functionally normally — which Krugman surely knows better than anyone.
Through a series of extraordinary measures — zero percent interest rates, Quantitative Easing, Operation Twist, stuffing its balance sheet with dubious collateral from the Too-Big-to-Fail banks — the Federal Reserve has effectively disabled the credit markets and the disciplinary role it plays checking government spending.
The collateral damage from that is hard to understate:
Since Alexander Hamilton established the market for U.S. Treasury bonds in 1790, they have been the fulcrum for the bond market as a whole. Risk premia on other classes of bonds are all measured as so many basis points above Treasurys at all terms to maturity. If their yields are artificially depressed, so too are those on private bonds. The more interest rates are compressed toward zero, the less useful the market becomes in reflecting risk and allocating private capital, as well as in disciplining the government.
–Ronald McKinnon, “Where are the Bond Vigilantes?”; The Wall Street Journal (9/30/2011).
Too complicated?
Try this analogy instead.
The world financial crisis resulted from Wall Street recklessly speeding — and the government letting (encouraging?) it.
No surprise, the system crashed three years ago.
Now, instead of enforcing 55 mph speed limits (and throwing the reckless driver in jail), the Federal Reserve has opted to disconnect the speedometer before once again gunning the engine.
P.S.: Of course, the other bizarro reason the government can borrow so cheaply (at least for now): today’s slow motion financial panic has investors everywhere piling into perceived “safe” investments, driving down interest rates.
