The Bond Market Bogeymen and the Liquidity Trap
(or Our Nation's Patriotic Creditors)

I seem to be writing a lot about Krugman's thoughts lately. It must be because he's on fire. Also he preciently wrote a book titled Depression Economics which is the land we currently inhabit.

Howard Kurtz on Krugman. Looks like we are in debt to Harold Raines and Gail Collins for raising Krugman's profile.

I found Krugman's columns frustrating during the Democratic primary, but he was on the right side during the health care reform debate and has been hitting on all cylinders since.

Exhibit A is his and Robin Wells's two New York Review of Books articles The Slump Goes On: Why? and The Way Out of the Slump. It's too bad more bloggers haven't engaged them on their articles.

I wrote about the first piece here, here and here.

The second article focuses on what needs to be done to get us out of the slump. They write "most of the time, we count on central banks to engineer economic recovery following a slump, much as they did after the 2001 recession." Usually a central bank will cut short-term interest rates, but the Federal Reserve Bank has already reduced rates to near zero.

Applying the Taylor rule, "the Fed's main policy rate, the overnight rate at which banks lend reserves to each other should currently be minus 5 or 6 percent." So we're in a liquidity trap where adding more liquidity has no effect.

Ideally the government should step in to spend with fiscal policy where the private sector will not.* But there isn't much chance of getting any significant stimulus through the US Congress. However the Fed can perform some uncoventional monetary policies. They could buy long-term government debt and long-term private debt directly thereby reducing premiums and reducing long-term rates. This is known as "quantitative easing" or QE.

The Fed could also state its intention of raising the inflation target to 3 or 4 percent. Inflation would help get businesses and people to spend and would help consumers work off debt and deleverage. Once consumers work off their debt, demand will pick up, followed by businesses hiring.

Wells and Krugman also present other ways to reduce consumer debt: allow mortgages to be covered by personal bankruptcy procedures or "as Bill Gross of the bond fund PIMCO has proposed, allowing Fannie Mae and Freddie Mac to engage in mortgage refinancing."

Finally Wells and Krugman take China and Germany to task for following beggar-thy-neighbor strategies. The essential problem of the world economy is an excess of savings, with not enough borrowers. Countries that run large trade surpluses in this environment "are propping up their own economies at the rest of the world's expense." Wells and Krugman don't mention it, but  Matt Yglesias and Barry Eichengreen have suggested that one way to counter China and Germany would be for the Federal Reserve Bank, the European Central Bank and Japan's Central Bank to do rotating/complementary devaluations which would reduce debt and spur demand.

A common thread running throughout the debate on ways to emerge from the slump is an irrational fear of the bond market.** People talk as if we were not up against the zero bound. Conventional wisdom seems to accept that Obama's fiscal stimulus, TARP, and the Fed's unconventional policies helped saved us from a second Great Depression. However conventional wisdom is now arguing that in the wake of Greece and the European Sovereign Debt Crisis and the rise of the Tea Party, anymore stimulus or unconventional behavior by the Fed to help lower record unemployment rates will upset the nation's creditors. People say the "bond vigilantes" will exact vengeance, but there has been no evidence that the conventional wisdom is doing anything more than making excuses for inaction. Rates on 10-year Treasuries have dropped down around 2.6 percent.

Maybe the Fed will butch up after the November election. Calculated Risk writes "(note: many people think that Hilsenrath has taken over Greg Ip's role (now at the Economist) and leaks to Hilsenrath [at the Wall Street Journal] might be part of the Fed's communication strategy).... Although QE2 isn't a done deal, the odds are very high that the next round will be announced on November 3rd at 2:15 PM ET."

And if the bond market ever does gather its toys and heads home, just raise taxes. "Soaking the fat boys" is a much better way to go than borrowing from them.
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* Krugman had a nice blog post on fiscal stimulus and the Arsenal of Democracy.
** In Bob Woodward's book on the Clinton White House titled the Agenda, he recounts a story where at the beginning of his first term Clinton raged "I hope you're all aware we're all Eisenhower Republicans.  We're Eisenhower Republicans here, and we are fighting the Reagan Republicans. We stand for lower deficits and free trade and the bond market. Isn't that great?" Clinton was upset that Treasury Secretary Rubin and Fed Chairman Greenspan had counseled him to moderate his spending bill so as not to upset the bond market gods which Clinton ended up doing.