Great Leap Forward

Krugman is Right; The Bond Vigilantes are Impotent


In his column Paul Krugman pretty much nails the MMT approach to interest rates on sovereign government debt: Forget the Bond Vigilantes; they have no perceptible impact on those rates.

The short rates have to compete with the Central Bank’s overnight policy rate (fed funds in the US). Since very short maturity treasuries are nearly perfect substitutes for overnight lending between banks, short rates track the overnight rate. And that is set by the Central Bank, plain and simple.

Longer rates on Treasury debt are determined largely by expected future short term rates–which will be set by the Central Bank. Krugman is correct that it is a bit more complicated (there’s risk of capital loss if short rates rise; plus there are “habitat” preferences and possibly some liquidity preferences) but that’s close enough. If some Bond Vigilantes go all crazy on us and run out of Treasuries after a credit rating agency downgrade, there will be plenty of noncrazy investors who will eat them for lunch. Look, there have been crazy investors who year after year after year place bets on impending Japanese default. Ain’t going to happen. You should take the other side of their bets against Japan–its free money. They want to pay you for their stupidity.

Ditto US and UK, as Krugman is arguing. Bet on the sovereign’s side.

Here’s a key passage from Krugman:

It’s very hard to come up with any reason why either the US or the UK might default, since they can simply print money if they need cash. And given the absence of real default risk, long-term interest rates should be more or less equal to an average of expected future short-term rates (not exactly, because of maturity risk, but that’s a fairly minor detail). So if you expect the US and UK economies to be depressed for a long time, with the central bank keeping rates low, long rates will be low too — end of story.

Krugman goes on to argue that the inflation mongers (including gold bugs) are also wrong. There’s no significant inflation on the horizon.

I’d go a bit farther than him, however. Even if inflation should rear its ugly head, there’s not much an investor can do about it. You always go for the highest nominal return you can get, given your taste for default, liquidity, and interest rate risk and other possible nasty events. Expected inflation doesn’t change that–since inflation is by definition a nominal problem.

Other than inflation-indexed bonds (which the US Treasury happily sells, and which come moderately close to an inflation hedge) you cannot truly hedge against inflation. People have thought up complicated commodity indexes but what you really need is a price hedge for a personalized basket of goods and services that you will want to buy in the future.

No one is selling that hedge. Gold ain’t it unless you consume only gold. King Midas found that to be a curse–as you no doubt remember.

32 Responses to “Krugman is Right; The Bond Vigilantes are Impotent”

princess1960November 25th, 2012 at 4:43 pm

ok i like PK because he is very clear what write ..(this does'nt mean i am agree with him allways )
inflation in USA and UK look the same but is'' not'' maybe (spending les)administration will help inflation (not gold)
or maybe smaller GV …what you think?
thank you
ah PK is very smart economologos

AndrewMGarlandNovember 26th, 2012 at 12:03 am

Mr. Wray, you repeat and support Krugman's conclusion that "There’s no significant inflation on the horizon."

That isn't comforting. The "horizon" for financial shocks is typically today. There is a graph of past prices ending today, and an extrapolation into the future based on someone's judgment. What is the practical basis for predicting "no significant inflation" other than that extrapolation into the foggy future?

Then, you worry me when you allow that there may be significant inflation.
(Wray):"Even if inflation should rear its ugly head, there’s not much an investor can do about it." So, inflation might happen despite the horizon. Krugman might be wrong, unthinkable in your preceeding presentation.

I would be happier if you could give some examples of societies with significant inflation which did nicely. I thought that "ugly head" meant inflation was a scourge, not a benefit. Instead, when you allow that significant inflation may occur, you propose the calming non-sequiter that investors can't do much about it anyway.

That is like saying a flood will not occur, but even if it does, don't worry, because you can't escape it anyway. What about the damage from the flood? If you can't escape, then it would be prudent to stay far away from the conditions which might cause that flood, like the dam breaking, or like expanding the money supply by $80 billion per month.

Even if investors (Wray):"cannot truly hedge against inflation", they just might decide that owning some basket of goods and services would be better than losing 10% or more yearly holding government bonds. Even if that basket is not perfect and doesn't have an attached coupon. They won't be calmed by the government proclaiming: "Don't worry about our bonds; we can print up all the money we need to pay you off".

(Wray, edited): "Gold isn't a perfect hedge, unless you consume only gold. King Midas found that to be a curse, as you no doubt remember."

This statement worries me a lot. You are arguing that investors might as well hold government bonds, despite inflation losses, because owning gold doesn't work out well, as shown by a Greek myth. I doubt your other statements when that is how you support your last point.

No one directly consumes cash, US Treasurys, or gold. The question is, do you want to own Treasurys or cash when the government and central bank are creating both types of paper at flood-level volumes?

jerryNovember 26th, 2012 at 6:49 am

Very good comments! I would also submit the following article from zerohedge:

Apparently the Fed will *have* to keep running QE for the foreseeable future just to keep up with the level of delevering in the shadow banking sector, which they seem to believe will result in an explosion of asset prices in the end game.. any thoughts?

JordanNovember 26th, 2012 at 9:05 am

@ Andrew
"I would be happier if you could give some examples of societies with significant inflation which did nicely."
This is interesting since it says that you never compared inflation rate with growth of economy. If you did you would know that growth almost always requiers inflation, higher growth higher inflation. See any country at any time of decent growth and compare it to corresponding inflation.
Your assumption is that inflation is bad. Do you think hiperinflation when someone says word inflation? Did you really think about it or you just trust economists who say this?

Aaa AaaNovember 26th, 2012 at 2:03 pm

Amazing how people forget things, bond vigilantes don't exist untill they do, and then hell breaks loose in matter of weeks. The only reason why they are not here yet is because money printing is still moderate vis-a-vis the size of the debt deflation looming…
You have achieved the very hard-to-achieve goal of being dumber than Krugman…
The notion that you can do anything just because you print your own money is so imbecile it hurts to read it from people with a degree in economics.

Dominic DoucetNovember 26th, 2012 at 3:29 pm

Hi! I'm not an economist, and I have a question:

Mr. Wray is saying that we are not experiencing inflation, at least we are not experiencing a great deal of inflation.

But, the way I see it, American median income (adjusted for inflation) has dropped to 1997 level. During this times, Consumer Price Index (which is a proxy for inflation) rose (42% precisely). In a way, people are relatively poorer right now.

Why we are not using an inflation index which is relative to median income? It's true that an inflation rates of 2% is not high. But if, during this times, median incomes of household dropped 25% of his value. My instinct will tell me that we are experiencing a great deal of inflation (relatively to income).

What is wrong with my proposition (that we are experiencing a great deal of inflation while median income has dropped).

Thank you,

Dominic Doucet (Main language is not English).

LRWrayNovember 26th, 2012 at 9:55 pm

All plausible evidence shows that growth rates are higher with moderate (single digit) inflation; altho evidence shows that inflation rates above 40% do lead to lower growth.Below that, there is no evidence of detrimental effects. I know that our goldbugs go ballistic at inflation rates of 3 or 4%, but there just isn't any evidence in favor of a growth tradeoff at rates that low, or of creeping inflation. That said, inflation is a political issue. Populations hate inflation, no matter how irrational the hatred. They also hate many thing, such as alien abductions, forced anal probes by Martians, and lots of other things that are far more terrifying than inflation. I get the message, and so I fight inflation, too. If it rears its ugly head, let's fight it. Best way: price controls, with severe penalties on anyone who raises prices–gallows or deportation to a colony on Mars. Where aliens have the probes and are itching to use them.

AndrewMGarlandNovember 27th, 2012 at 3:52 am

Mr. Wray,

You propose that populations irrationally hate inflation. Isn't that because the value of cash savings are reduced and the average salary lags inflation? Even if interest rates and salaries eventually catch up to higher interest rates and prices, the workers have lost some value along the way. That isn't merely a nominal problem for them.

Some people worry about alien invasions. That doesn't mean that all of the worries by all of the people are irrational.

"Gold bugs" predict inflation from an increasing money supply caused by the Fed buying Treasurys in large amounts, monetizing a good part of US debt. If inflation follows, your solution is to take over commerce and set all prices. Wow. Do you have an example where that worked out well?

Short of a totally planned society, what is your next best way of fighting inflation?

BogwoodNovember 27th, 2012 at 1:06 pm

The vigilante that didn't bark is an ominous sign. In the era of cheap energy there were many enterprises worthy of debt. Now,on average, there are none. Trying to store wealth in this setting costs money rather than making money. Negative rates are the new normal,due to resource considerations and not the Fed. If there were trillions in alternative investments the Fed would be powerless. The government is defaulting gradually and will default more spectacularly on its 85 trillion dollars of future promises. The Fed cannot print the resources future pensioners expect.
By borrowing in the trillions the US government is short the dollar at the first level, and short the resources the dollars buy at the next level. Is that a hedge fund you want to own? Could there be a conflict of interest?

ErichNovember 27th, 2012 at 1:31 pm

For the US certainly there is no immediate danger with printing their money to buy stuff from abroad. All of the emerging countries are happy to buy dollars to avoid a depreciation of the dollar. This way the US can get off easily with huge trade deficits year after year. Part of the deficit is financed by the big banks who have the means to convert part of these dollars into their own pockets. This will not change too soon, so for a while th US is save.
But of course this would not apply for countries like Greece. If they leave or have to leave the Euro zone, nobody will sell them oil, food or other urgently needed stuff for newly printed Drachme. They would have to produce stuff that they can sell to get the dollars to buy these.
So don't be too sure in the long run that everybody in the world will accept printed paper for real stuff, forever.

LRWrayNovember 27th, 2012 at 8:26 pm

Wow. Yes. Galbraith, Sr, WWII, price controls and rationing.Or if you prefer Republican price controls, Nixon.

LRWrayNovember 27th, 2012 at 8:27 pm

Boggie: currency issuer cannot be short its currency. No ominous signs. Except in the wheat fields. Watch for the aliens.

BogwoodNovember 28th, 2012 at 1:02 am

You can be short anything you can borrow,even while you make more of it,like many of the gold miners were for years. That is one of the problems. But yes, coming to economics texts late in life I am more sympathetic to the biophysical/ecological view. When economic texts return to wheat as their major concern the circle will be complete. It has only been a few years.

lkofenglishNovember 28th, 2012 at 3:04 am

well they certainly exist in Europe ironically enough. why is the place that has the biggest problem with deflation is the one that has the highest interest rates? and of course "the answer is easy: the Government is lying about inflation." In Germany's case "our inflation…your problem." the whole thing is backed by Aircraft carrier battle groups, infantry divisions and spy sattelites anyways.

GuestNovember 28th, 2012 at 6:28 am

But what is it that allows us to be a sovereign currency issuer? If this is a matter of choice, and if fhe choice confers such massive advantages on the sovereigns that make that choice, why are there countries in the world like Greece, or Spain, or Italy? It seems to me that there may be a certain set of conditions that allow us (and some others) to be sovereign currency issuers. What are those conditions, and how could they break down? (I don't mean this question as a veiled prediction of Armaggedon, Martians, or any other kind of prediction. I mean it as a genuine question.) Maybe there are reasons why the risks are exceptionally small.

The fact that our currency is the world's preferred reserve currency might be one such condition. Another might be that in exchange for this privilege, our military is nearly the size of all the rest of the world's put together, and is responsible for protecting those pesky global shipping lanes and that crazy global airspace. You know, all that stuff that exporting nations depend on. This is, of course, speculative.

Guest (same one)November 28th, 2012 at 6:29 am

BTW — I don't think there is any significant risk of inflation, either. I wonder whether there is still a risk of rapid deflation. I'm one who doesn't believe that all the phony paper on bank balance sheets has been cleaned up to a point where it's no longer a danger. But I am very aware of the fact that I could have this wrong. I've been struck all along by how the best and most honest economists disagree on this crucial issue.

(I was required to edit and split up this "too long" comment. I wonder why.)

AndrewMGarlandNovember 28th, 2012 at 6:33 am

Mr. Wray,

What am I to think of this report about the success of Nixon's wage a price controls to counter inflation?

Nixon’s price controls
8/8/2008 – EconoMonitor by Michael Pettis
=== ===
Today is an anniversary of sorts. Thirty-seven years ago, in 1971, President Nixon stunned the US by announcing the imposition of extensive wage and price controls in an effort to reverse rising inflation in the US. In retrospect it is pretty clear that the price and wage controls were unlikely to reverse several years of booming money creation
=== ===

Quoted in that article, from The Econ Review
=== ===
In a move widely applauded by the public and a fair number of (but by no means all) economists, President Nixon imposed wage and price controls. The 90 day freeze was unprecedented in peacetime, but such drastic measures were thought necessary. Inflation had been raging, exceeding 6% briefly in 1970 and persisting above 4% in 1971. By the prevailing historical standards, such inflation rates were thought to be completely intolerable.

The wage and price controls were mostly dismantled by April, 1974. By that time, the U.S. inflation rate had reached double digits. While there were skeptics in August, 1971, there were a great many who thought “temporary” wage and price controls could cure inflation. By 1974, this notion was thoroughly discredited, and attention gradually turned toward a monetary approach to inflation. In a complete reversal, the policy to curb inflation in now thought to be an increase in interest rates rather than an attempt to hold them down.
=== ===

L. Randall Wray L. Randall WrayNovember 28th, 2012 at 11:02 pm

Bog: these are keystroke liabilities. Can you run short of your own IOUs? Even if you ran out of paper or computer disk space, you could scratch them on rocks, trees, clay…..

L. Randall Wray L. Randall WrayNovember 28th, 2012 at 11:04 pm

I don’t know. Wage and price controls work, of course. Getting off can be difficult. In any case, that was the Republican version–not something I’d want to try but I thought you might like the variety of choices.

LRWrayNovember 29th, 2012 at 1:44 am

Again: EMU nations are not sovereign in the sense we use the term and are suffering exactly the problem with vigilantes that all MMTers predicted a decade ago. Our only surprise was how long it took the vigilantes to come with the pitchforks.

Can we finally dispense with the bogeyman? Euro using nations are not fully sovereign nations. The US, Japan, UK, Turkey, and dozens of other countries cannot suffer the fate of Euroland because they issue their own floating rate currencies.

LRWrayNovember 29th, 2012 at 1:46 am

No. Sovereignty is a separate issue from international reserve currency. There are many sovereigns–potentially as many as there are countries. There is one reserve currency; not likely you can ever have more than one or a couple of those.

GuestNovember 30th, 2012 at 4:30 am

Thanks for responding. Of course, that's right. My question was illogically put. Of course there are as many potential sovereign currencies as there are sovereigns. But what makes it possible for the US to be one of them, and then do pretty much as it likes, and still have nothing to fear from the bond vigillantes? Why won't they go after us?

Or to put it another way, why are Greece and Spain (or anyone else) constrained? They chose to be constrained can't be the answer. Why did they choose to be? Why would any country choose to be, when it could imitate the US instead?

There has to be a reason. That's what I'm trying to discern here.

GuestNovember 30th, 2012 at 4:54 am

Okay, here's what Professor Dolan says: "Some countries are in an intermediate position between Greece and the United States. Take Latvia, for example. Although Latvia issues its own currency, the lats, its solvency is constrained in two ways. First, the Latvian government has borrowed large sums in foreign currency. To the extent it has done so, it is in the same position as Greece; its solvency depends on having a way to obtain the foreign currency it needs to meet those obligations."

On the other hand, the US doesn't need to obtain "large sums in foreign currency." Why should it need to, when the US$ is the world's reserve currency? This is what I was driving at.

Guest (con't)November 30th, 2012 at 4:56 am

When I listen to MMT talk about the US as a sovereign issuer of a potentially endless supply of currency, which its citizens accept as "real money" because it is legal tender not merely for extinguishing private debts but for extinguishing public ones as well — in other words, we must produce dollars (and need only produce dollars) in order to pay our taxes — the term that comes to mind is "police power" as lawyers use it. That is, as a term of art.

We're not too far now from filling in the steps necessary to our conclusion, an essential component of which is the phrase "armed forces." Well, that seems to me like one possibility at any rate. My mind is open.

L_Randall_WrayNovember 30th, 2012 at 12:12 pm

Guest: (if you are all the same person)
1. There is an element of force in imposing taxes. But it can be done in the public interest
2. Greece, et al, chose to give up their currency sovereignty. Motives vary. Sometimes it is fear of inflation. Sometimes it is desire to have an external force (ie Germany) discipline national politicians. In the case of europe it was all very complex and included some higher motives–no more world wars, unification.
3. None of the developed, sovereign currency nations has to borrow in foreign currencies. There are well-developed foreign exchange markets. There are some developing nations who face no external demand for their currencies. They are in a different situation. You might read my 2012 book: Modern Money Theory, Palgrave..

AJSDecember 3rd, 2012 at 4:18 am

Thanks for this Prof Wray
I Think one reason why there is an issue in people's minds about inflation is that they don't get the destruction of money going on after the housing bubble.

In the housing bubble years massive amounts of money entered the system via lending – banks do not lend against reserves but just create the $ and the debt. These $ were then spent into the economy.

Now that has been trying to unwind and when people pay off their debts money is sucked out of the economy (ie the reverse of what was going on before). I read somewhere that the US took a several trillion $ reduction in property values – so imagine the impact on spending and the desire to reduce mortgages.

For inflation to occur you need net government spending (ie new money entering the economy) to be more than this drive by us householders to reduce our debts (and banks want to unwind their balance sheets as well). Of course if we saw economic activity around us (infrastructure repair and the workers spending their wage money) we might also start to feel more comfortable and spend too.

Apologies for the non-economist phrasing – but I wanted to emphasise the way money is sucked out of the economy when people pay of their debts – hence low risk of underlying inflation right now. This needs to be distinguished from commodity inflation (eg short supply of wheat etc). But inflation is the least of our worries, far more important is the impact of long term unemployment and the lack of investment in the real economy.


John RosenfieldDecember 12th, 2012 at 11:37 pm

I'm not sure to whom you are responding – hopefully not to Ms. Doucet. She has an excellent point to make. For people making near the median income, their purchasing power has dropped considerably in the last fifteen years. Often people from other countries who move to this country can see principles and concepts that are not obvious to those who have lived here all their life. I applaud her comment.

At the same time I applaud you lecture that you gave at Columbia University Law School for the Modern Money lecture series. I recently listened to your lecture online from the archive section of the recorded series. I strongly recommend this lecture series to all of your readers. The lectures are free to the public online at To view past lectures the reader needs to click on Materials in the left hand column and then click on Archives. Professor Wray appears in the first lecture. The future lectures can be viewed in real time, and the dates and times appear by clicking on Schedule in the left hand column.

John Rosenfield

CalgacusDecember 26th, 2012 at 8:51 am

Since Intensedebate seems to be posting my comments again – here is an old one I worked at 🙂

Well, I think the poor old impotent bond vigilantes should have their hedge, or they might jump out from behind it and scare people. They have suffered enough. They should get behind a Treasury program to issue inflation hedges called "dollars". These dollars should be tied to an asset which has a great record for appreciation in terms of just about anybody's personalized basket of goods and services that they will want to buy in the future: human labor. The government should issue a fixed amount of dollars to anyone who wants to give the government their scarce labor. Maybe it should be called the AIG – Anti-Inflation Guarantee. Though some might not like that acronym. Maybe Vigilante's Inflation-Abating & Growth Restoring Act is better. Wonder why nobody's thought of it yet.