Has Anyone Seen Those Vigilantes?

The bond vigilantes are MIA, observes Ronald McKinnon, a professor at Stanford. This is unusual, he advises. “In past decades, tense political disputes over actual or projected fiscal deficits induced sharp increases in interest rates—particularly on long-term bonds.” But as anyone who watches the Treasury market these days knows, rates have been falling, and for longer than many veteran market pundits and traders expected. To put it simply, these are extraordinary times… still. On that point, at least, there’s no debate.

“Even with great financial disorder in the stock and commodity markets since late July 2011, today’s 10-year Treasury bond rate has plunged below 2%,” McKinnon notes. “The bond market vigilantes have disappeared.”
The disappearing act has consequences, he continues:

Without the vigilantes in 2011, the federal government faces no immediate market discipline for balancing its runaway fiscal deficits. Indeed, after President Obama finally received congressional approval to raise the debt ceiling on Aug. 2, followed by Standard & Poor’s downgrade of Treasury bonds from AAA to AA+ on Aug. 5, the interest rate on 10-year Treasuries declined even further… The more interest rates are compressed toward zero, the less useful the market becomes in reflecting risk and allocating private capital, as well as in disciplining the government.

What’s going on? McKinnon argues that “the vigilantes have been crowded out by central banks the world over.” This isn’t normal, he complains.

When interest rates dipped in the past, at least part of their immediate expansionary impact came from the belief that interest rates would bounce back to normal levels in the future. Firms would rush to avail themselves of cheap credit before it disappeared. However, if interest rates are expected to stay low indefinitely, this short-term expansionary effect is weakened.

McKinnon is effectively saying that low rates are the problem, the implication being that tighter monetary policy will cure not only the unusual state of interest rates but the economic conditions that induced the low interest rates in the first place. But such a policy isn’t likely to be productive at a time when inflation expectations are falling, money demand is rising, the economy is weakening, and the Fed is engaging in passive tightening via monetary policy, zero nominal rates notwithstanding. Switching to an active policy of tightening, in other words, sounds a bit premature, to put it mildly.
Whereas McKinnon is chomping on the bit for tighter policy, others look at the world and call for the opposite. Martin Wolf, for one, thunders:

It is the policy that dare not speak its name: the printing press. The time has come to employ this nuclear option on a grand scale. The alternative is likely to be a lost decade. The waste is more than unnecessary; it is cruel. Sadists seem to revel in that cruelty. Sane people should reject it. It is wrong, intellectually and morally.

For the reasoning, Wolf cites a speech from earlier this month by Adam Posen, an American who sits on the Bank of England’s monetary policy committee:

Both the UK and the global economy are facing a familiar foe at present: policy defeatism. Throughout modern economic history, whether in Western Europe in the 1920s, in the US and elsewhere in the 1930s, or in Japan in the 1990s, every major financial crisis-driven downturn has been followed by premature abandonment—if not reversal—of the macroeconomic stimulus policies that are necessary to sustained recovery. Every time, this was due to unduly influential voices claiming some combination of the destructiveness of further policy stimulus, the ineffectiveness of further policy stimulus, or the political corruption from further policy stimulus. Every time those voices were wrong on each and every count. Those voices are being heard again today, much too loudly. It is the duty of economic policymakers including central bankers to rebut these false claims head on. It is even more important that we do the right thing for the economy rather than be slowed, confused, or intimidated by such false claims.

Even the former bond vigilantes seem inclined to agree these days.