Paul Krugmanblogged last night that he has recently spoken with "reasonable people" who fear bond vigilantes will begin bidding up the yield on U.S. treasuries any day now.
But those fears, he says, seem pretty irrational — not because it couldn't happen, but because the effects would be mild.
"It’s much harder than most people seem to imagine to tell a Greece-type story about a country with its own currency and a floating exchange rate," he writes.
Krugman actually drew up a model (on an airplane, no less!) he says proves his case.
He uses the following formula to represent the vigilante-phobics' case...
Where "i" is the interest rate on sovereign debt, "i*" represents a theoretical fixed or pegged rate, and p is premium.
Plotted against GDP ("y"), you get something like this:
Krugman:
In this picture, an attack by the bond vigilantes is indeed a bad thing. As indicted by the arrow, it drives up interest rates and leads to economic contraction. And I suspect that something like this is what, say, Bowles and Simpson imagine might happen to America.
But the U.S. does not exist under such a regime.
Rather, we operate through the Taylor Rule, which says interest rates should move inversely to GDP expansion. Here's what that looks like ("IS" a total-spending curve):
Krugman:
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.
And in typical Krugman fashion, concludes: "So what are the fiscal fear types thinking? Basically, they aren’t."
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