Franc thoughts on Bond Vigilantes by Krugman

Franc Thoughts on Bond Vigilantes
by Paul Krugman
NOVEMBER 23, 2012 12:48 PM

Suzy Khimm writes about the contrast between what financial industry honchos say worries them and what financial markets seem to be saying. The honchos declare that failure to reach a Grand Bargain would

spark a damaging loss of confidence in the U.S. government’s fiscal prospects, a run on Treasury bonds, and a spike in interest rates.

But the bond markets are saying what me worry, with long-term rates at near-record lows.

What Khimm doesn’t note, however, is that the problem with bond vigilante scare tactics runs even deeper than that — because it’s actually quite hard to tell a story in which a loss of confidence in U.S. bonds hurts the real economy. Why wouldn’t it just drive down the dollar, and thereby have an expansionary effect?

Yes, I know, Greece — but Greece doesn’t have its own currency. What’s the model under which a country that does have its own currency and borrows in that currency can experience a slump due to an attack by bond vigilantes? Or failing that, where are the historical examples?

The closest I can come to anything resembling the danger supposedly lurking for America is the tale of France in the 1920s, which emerged from World War I burdened by large debt, and which did in fact face an attack by speculators as a result. Yet the French story does not, if you look at it closely, offer any support to the deficit scare talk we keep hearing.

So, France did indeed have a big debt problem. Here’s debt as a percentage of GDP, from the IMF debt database:

[graph]

How did France achieve that big drop in debt after 1925? Basically by inflating it away.

And markets sort of saw that coming. This study (pdf) by the Bank of France show medium-term interest rates (black line) rising substantially for much of the 1920s, before dropping off sharply:

[graph]

It’s important to note, however, that France wasn’t a depressed economy in the 1920s, and therefore didn’t look much like America today:

[chart]

Meanwhile, the really big effect was a sharp depreciation of the franc, which made France highly competitive and strengthened the economy:

[chart]

But what about the brief but nasty slump in 1927? That wasn’t caused by spiking interest rates; it was, instead, caused by fiscal austerity, by the measures taken to stabilize the franc.

So even when we look at the closest thing I can find to the scenario the deficit scolds want us to fear, it doesn’t play out at all as described.

It’s quite remarkable: our policy discourse remains largely dominated by fears of an event that the fear-mongers can’t explain in theory, and for which they can offer no historical examples in practice.