Tuesday, April 07, 2015
Apparently, I convinced Brad DeLong that the idea of a "bond bubble", though a slight misnomer, is not insane. Brad's explanation of the idea is a little convoluted, so let me see if I can boil it down to essentials.
Why can't a government borrow and spend infinite amounts of money? Well, interest payments might get too high, forcing the government to default. But what if interest rates keep getting lower and lower? As nominal interest rates go to 0, interest payments go to 0, so the govt. will always be able to make interest payments no matter how big the debt gets.
So all the govt. has to do in order to be able to borrow and spend infinite amounts of money is to get the central bank to keep interest rates at 0 forever, which the central bank can do by - basically - printing money and buying bonds from people and banks.
But what if people and companies stop buying the government bonds in the first place? Well, the central bank can just print money and buy the bonds directly from the government. (We call this "the full MMT." It is almost certainly the route Japan will have to take.)
So is this a free lunch? What's the danger? The danger is that all that money-printing will eventually result in a big inflation. A big inflation will also raise nominal interest rates, overwhelming the central bank's ability to keep them down. That will cause a government default.
So is this a danger for advanced countries right now? Well, markets have very low expectations for future inflation, and for future interest rates, for most rich countries. If you believe markets are efficient, this means that it's likely that governments can keep borrowing money, and central banks can keep printing money, without causing inflation - at least for now.
BUT, if markets are not efficient, then people could be underestimating the risk of a rise in inflation and interest rates. That is what people are afraid of when they talk about a "bond bubble." No, it's not a speculative bubble, but whatever. This is what I pointed out to Brad DeLong.
Note, btw, that a bond bubble isn't the only reason to take low inflation expectations with a grain of salt. Those low expectations could be based on people's predictions that governments and central banks won't engage in infinite-borrow-and-infinite-print policies. If governments surprise people by trying those policies, the markets could quickly adjust their expectations. You don't need a bond bubble to be afraid of a run on the currency - you just need Goodhart's Law.