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The Waning of the Bond Market Vigilantes

It wasn’t so long ago that American politicians lived in fear of the bond market. During the Clinton administration, James Carville famously said that “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” That phenomenon gave rise to the concept of the “bond market vigilantes,” which Krugman loves to employ.

But today, the bond market vigilantes are not much in evidence. Or rather, they are in evidence, but they suddenly seem unable to have much of an impact on U.S. fiscal policy. Bill Gross, of the ludicrously enormous bond fund PIMCO, is running around screaming about the need for more borrowing and more stimulus. But he has no  effect, because it turns out that while bond investors have powerful ways of constraining U.S. government borrowing, they have only indirect and weak means of expanding it.

The United States has a large debt that is routinely rolled over, and it generally runs a budget deficit (Clinton interregnum aside). If bond investors start demanding higher interest rates on government debts, this immediately raises the cost of borrowing for the U.S. government. This, in turn, has knock-on effects throughout the economy, as interest rates rise for everyone and economic activity is thereby constrained. For these reasons, the U.S. government has powerful incentives to avoid doing things that cause the interest rate on treasuries to rise.

Today, however, we find ourselves in the opposite situation: what the bond market seems to want most of all is for the U.S. to borrow more money and stimulate the economy. That’s the best explanation for the incredibly low yield on Treasury bonds, which is negative in real terms over some time periods. And yet the U.S. is not borrowing more; instead both parties are demanding insane policies that will cause a second recession, ostensibly based on fallacious notions about the magical effects of budget cutting and a nonsensical conception of the relationship between government and household finances.

The problem here is that the power of the bond market is asymmetrical. When the interest rate on Treasuries go up, this immediately makes all of the government’s activities more expensive, and hence forces changes in fiscal planning. But when the interest rate falls to near zero, this only presents an opportunity for expanded borrowing, an opportunity that can easily be thrown away if the political system is too insane and dysfunctional to take advantage of it.

Hence the bond vigilantes sit on the sidelines, impotent and hopeless. Just like the rest of us.


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