Paul Krugman, in “The Simple Analytics of Invisible Bond Vigilantes (Wonkish)”, has lent his support to the view, emphasized by modern monetary theorists, that bond vigilantes cannot impede a sovereign currency issuer. Krugman has made this important observation in the past, but this time he spells out his reasoning, step by step, and the key points align closely with that of modern monetary theory (MMT). To illustrate his reasoning, Krugman links to a short paper, which includes a simple model he put together while in the air, perhaps somewhere over water between lands Neoclassical Synthesis and Modern Monetary Theory. The model is of the IS-LM variety, so some may prefer to look away while reading. Nevertheless, the potential for an advance in public understanding seems significant. Some people may be more inclined to adopt this better understanding of currency sovereignty thanks to Krugman lending his weight to it.
These are the points Krugman identifies as critical in the case of “the United States (or for that matter the UK)”:
Greece didn’t have its own currency, and therefore didn’t have its own monetary policy or its own exchange rate. We do. …
… an attack by bond vigilantes has very different effects on a country with a fixed exchange rate (or a shared currency) versus a country with a floating exchange rate.
In short, “we have our own currency and a floating exchange rate.”
By way of explanation, Krugman writes:
Think about it this way: with the Fed setting interest rates, any loss of confidence in US bonds would cause not a rise in rates but a fall in the dollar – and a fall in the dollar would be a good thing, helping make US industry more competitive.
He then adds an important caveat that is very familiar to modern monetary theorists:
Things will be different if you have large debt denominated in foreign currency – but we don’t.
So what are the fiscal fear types thinking? Basically, they aren’t. But to the extent that they do have a model … they’re imagining that American macroeconomics are just like those of a country on a fixed exchange rate with no independent monetary policy.
All this is both interesting and heartening. Clearly, Krugman has based his argument on the following observable facts:
1. The US government is a currency issuer, not currency user.
2. The US government allows the exchange rate to float.
3. The rate of interest under a flexible exchange-rate sovereign currency regime is set as a matter of policy rather than being market determined.
4. The US government does not have large debt denominated in foreign currency.
These four points are precisely the points emphasized by modern monetary theorists, 1 and 2 taken together being the meaning of currency sovereignty and the characteristics of what modern monetary theory (MMT) describes as a “modern monetary system”.
From a heterodox perspective, of course, the IS-LM is not an ideal choice of model, it having been disowned long ago by its creator (Hicks), so Krugman’s working will not win the hearts of many Post Keynesians and modern monetary theorists. Still, the IS-LM model remains a stalwart in the mainstream, and we are not the ones in need of convincing. Perhaps Krugman’s argument will have better persuasive power with insiders, or at least with the many in the general public who understandably, if unfortunately, place their faith in the authority of mainstream thinkers in prominent positions rather than attempt to reason for themselves.
In any case, Krugman’s view strikingly resembles the MMT position on what is a fundamental point: markets cannot dictate the terms on which a currency sovereign issues its own liabilities. (For more on this point, see here and here.) This consistency with the MMT position follows recent research coming out of the BIS that seems to be moving the mainstream view closer to Post Keynesian and MMT understandings of monetary policy. For example, previously I have linked to a 2009 paper, Unconventional monetary policies: an appraisal, which rejects money-multiplier reasoning and corrects common misunderstandings of quantitative easing. (For further discussion of recent shifts in orthodox monetary research, see a couple of old posts, here and here.)
Despite differences in analytical framework, hopefully Krugman’s post on the “invisible bond vigilantes” will help to move the policy discourse in the right direction.