The Mainstream Economists (Finally) Realize Bond Vigilantes are Mythical….

It’s interesting to see the mainstream economists now telling everyone how there are no such things as bond vigilantes in the USA (see DeLong and Krugman here).  This wasn’t always the case.  Krugman and Delong were once fearful of bond vigilantes.  So it’s nice to see some flexibility in understanding here.

Anyhow, over the last few years I have published EIGHTY EIGHT articles regarding the bond vigilantes and why this persistent fear was a load of nonsense.  In the course of this effort I’ve explained why there was no bond bubble, why Europe’s crisis was different, why Tim Geithner didn’t understand what he was talking about, why Alan Greenspan didn’t understand what he was talking about and making other controversial comments (including criticisms of mainstream economists).

As Paul Krugman has said in the past, these weren’t small claims.  In fact, I’d argue that they were at the heart of understanding what was going on in the economy in the last few years.  Unlike Krugman’s original stance, this was never about “liquidity preferences” or “liquidity traps”.  Sometimes I feel like I am screaming into an empty hole here at Pragcap.  Maybe it is empty?  Anybody out there?

Anyhow, from a bond trader’s perspective, it was all rather self explanatory.  Fixed income traders front-run the Fed who tries to front-run the economy.  When you combined this with the understanding of how the monetary system works and how the US government can’t “run out of money” all the pieces fell into place.  And the conclusion was simple – bond vigilantes are mythical.  They don’t exist in the USA.  Yes, fixed income traders set prices of long bonds in the market, but these rates are an extension of short rates which are an extension of Fed policy which is an extension of current economic conditions….

In all likelihood, rising rates in the USA means the economy is better.  Low rates means the economy is still muddling through.  We shouldn’t fear rising yields.   We should welcome them.

Anyhow, it’s nice to see the mainstream catching on after all these years…..


Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Huh

    “Krugmand and Delong were once fearful of bond vigilantes. ”

    Maybe 10+ years ago, but for the entire time I have been following their blogs (since before the recession), they have been consistently ridiculing the idea of “invisible bond market vigilantes” (a term Krugman coined) with regards to the US. This is really quite a strange post, you are many many years late with this.

  • Frederick

    Many of us have been listening. Thanks Cullen.

  • Cullen Roche

    That’s 100% revisionist history. In 2011 Paul Krugman wrote:

    “A question (to which I don’t have the full answer): why are the interest rates on Italian and Japanese debt so different? ”

    “I actually don’t have a firm view. But it seems to be an important puzzle to resolve.”

    Later that year he solved the puzzle:

    “What has happened, it turns out, is that by going on the euro, Spain and Italy in effect reduced themselves to the status of Third World countries that have to borrow in someone else’s currency, with all the loss of flexibility that implies. In particular, since euro-area countries can’t print money even in an emergency, they’re subject to funding disruptions in a way that nations that kept their own currencies aren’t — and the result is what you see right now. America, which borrows in dollars, doesn’t have that problem.”

    Pretty cut and dry, but hey, I don’t expect economists of this stature to admit they were wrong even though it’s pretty clear that they were.

  • SS

    PK may have been decrying bond vigilantes, but not for the right reasons. The Japan post that Cullen posts in this article makes that pretty clear. But this article in 2010 is even worse. He uses the loanable funds theory (which is 100% bunk) to prove why yields aren’t going to rise. He then goes on to hedge himself stating that the government debt will still cause problems.

    “Now, there are real problems with large-scale government borrowing — mainly, the effect on the government debt burden. I don’t want to minimize those problems; some countries, such as Ireland, are being forced into fiscal contraction even in the face of severe recession.”

    He may have been right about bond vigilantes, but not because he actually understood what was going on.

  • Huh

    No you are being revisionist, I swear to you any reader of Delong or Krugman will find this post very very bizarre since “invisible bond market vigilantes” was pretty much Krugmans niche, it was one of his most popular topics of ridicule, it would be one thing if Krugman occasionally mentioned it in passing, but he literally spent his journalistic career in 2009 and 2010 repudiating the WSJ and others for their naive beliefs in bond vigilantes.

    I do not think the fact that he was questioning why interest rates was higher in Italy compared to Japan is especially relevant for interest rates in USA. He made absolutely no mention of bond vigilantes in the post you link to, in the post you link to he says:

    “What is true is that the Bank of Japan is keeping rates at zero, while the European Central Bank seems determined to raise rates. Is that enough to explain the difference? Or is it something about the absence of a proper lender-of-last-resort function?”

    That is not a bond vigilante story, that is a monetary policy story. There is absolutely nothing to suggest he was expecting bond vigilantes to raise Japanese rates. And also, why would he admit he is wrong when he has not made any affirmative statements in that post? He was just asking a question and saying he was not sure, no positive statements to be wrong about.

  • Mr. Market

    The words “Bond Vigilante” are so quaint. It’s better to talk about “Demand & Supply”. When even Bradford Delong & Krugman have surrendered then I wouldn’t be surprised to see those vigilantes show up in the (near) future.

    BTW: Didn’t you notice that municipal bonds have taken a hit lately ?

  • Cullen Roche


  • Cullen Roche

    Krugman has already admitted his model was wrong.

    “I rethought my views about advanced country debt and deficits after making a wrong prediction in 2003 (although in that case my mistake was in not taking my own model seriously enough).”

    And that post by SS shows it’s still at least partially wrong. The entire liquidity trap argument using loanable funds is wrong. Krugman is still a money multiplier believer. This was made clear in the Keen debate:

    “For in the end, banks don’t change the basic notion of interest rates as determined by liquidity preference and loanable funds — yes, both, because the message of IS-LM is that both views, properly understood, are correct. Banks don’t create demand out of thin air any more than anyone does by choosing to spend more; and banks are just one channel linking lenders to borrowers.”

    No, both views are not correct. This whole debate has NOTHING to do with “liquidity preference” and loanable funds. It has everything to do with the fact that bond trades in the USA know the US govt isn’t going to have trouble paying 100 cents on the dollar at bond maturation. Krugman maybe have been repeating all this bond vigilante stuff for years, but that doesn’t mean he was right about it.

  • Huh

    This is a very different claim, everybody knows Post Keynesians strongly disagree with Krugman on IS/LM (Krugman actually has a liquidity preference, not loanable funds theorem, and he describes “loanable funds theorem” as naive here: ), but this is academic, and a very different claim from accusing Krugman of believing in bond market vigilantes.

  • Huh

    Yes I am aware of him changing his mind in early 2000s (which is why I initially said 10+ years ago), and this stuff about liquidity preference vs Keens view on banking is academic and is far less pertinent; the point is he never once over the last 4 years claimed there would be an imminent attack by bond market vigilantes, and ridiculed the notion.

  • Robert Laden

    There is only one bond vigilante that matters. It’s the federal reserve. And far from being vigilant, they are accomplices to the theft of financial resources that is taking place. Regardless of the mechanics of how this happens, the U.S. government gets to spend an extra trillion dollars per year and the funding for that trillion dollars shows up on the federal reserve’s ever expanding balance sheet.

  • Cullen Roche

    I never said that he said that. Maybe I am jumping to conclusions, but I see a change in Krugman’s thinking in recent years. I see him beginning to understand that perhaps this was never about the liquidity preference. That maybe it has more to do with the credibility of controlling ones currency….But maybe I am jumping to conclusions….

    Either way, his explanation over the years has not been correct. This was never a “liquidity trap”.

  • SS

    Cullen, you should have titled this:

    “Mainstream economists finally realize bond vigilantes are mythical for the right reasons”.

    Now PK just needs to admit his liquidity trap theory was wrong and he’ll have come full circle.

  • The Undergrad

    Your not shouting into a black hole Cullen. I’ve been here every single day for over a year.

  • Cullen Roche

    It’s not about disagreeing. It’s about understanding how banking actually works. Krugman says banks are just choosing to sit on their reserves. That’s patently absurd. Banks always sit on their reserves. That’s all they can do with reserves. The amount of reserves in the system are determined by the Fed and the amount of lending in the economy has ZERO correlation to reserve balances because banks don’t lend reserves. Even the fed has explained this. It’s not a “disagreement”. It’s a misunderstanding by Krugman.

    The entire liquidity trap theory is wrong. I thought I explained that in the post. Perhaps it needs clarification.

  • Cullen Roche


  • Huh

    I do not really get what problem post Keynesians have with the idea of a liquidity trap, from wikipedia:

    “A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth.”

    It basically states that monetary policy, when rates are near zero, is ineffective; I understand why market monetarists and Austrians find this enraging, but this would seem to adhere to the ideas of Post Keynesians.

  • Mr. Market

    There’s a toxic combination brewing that could send US interest rates higher:
    - shrinking trade deficit.
    - rising budget deficit (on its way to ~ $ 1.8 trillion for FY 2013).
    - falling commodity prices.

  • Andreas Tirez

    I think Cullen Roche might be right: Krugman did implicitly say he changed his position on the importance of countries printing their own currencies and countries who don’t. In a May 2011 blog post he refers to a paper by Paul De Grauwe comparing the UK and Spain:

    And later, in September 2011, he says: “The best guide to recent events is actually a paper written this spring, by Paul De Grauwe (pdf). I have to admit that when I first read De Grauwe’s paper I didn’t grasp the full force of his argument about liquidity crises; but he now looks absolutely prescient.”

    Looks like a learning moment for Krugman. But the fact he’s so clear about it speaks for him, instead of against, I would say.

  • Cullen Roche

    100% agree. I think it’s great that someone of his stature would be willing to admit that a past model was flawed.

  • Johnny Evers

    Maybe bond vigilantes never believed the Fed would step in so forcefully to keep rates low — buying Fannie and other mortgage debt, buying distressed MBS, now stepping in to buy (or exchange, whatever you want to call it) Treasuries.
    But I believe that bond traders have the message now that rates will be low for a long time. Bond traders are now ‘front-running’ the Fed buy buying junk bonds because they know that if those issues fall in price, the Fed will step in. Remember Bernanke says his biggest mistake was not bailing out Lehman Brothers.
    The Fed will succeed in keeping rates low, but it’s going to have to buy Treasuries directly and also step into the muni market (just watch it buy up distressed California and Illinois debt.)
    The problem here is political, not economic. Why do some players get bailed out, while some (students, most obviously) do not.

    We’ve gotten so used to thinking of debt as an asset — as money — that we’ve forgotten the other side of it. Somehow we’ve gotten into a situation in which getting rid of debt is impossible.
    Seems to me we have a choice between a debt jubilee (and probable inflation) or bank and state failures, along with personal bankruptcies, leading to deflation. Either of those events would eventually lead to a rebirth.
    What Bernanke is doing just seems to put off the day of reckoning and make it worse when it does come.

  • joe

    how do you explain the massive amounts of cash being hoarded by corps? see microsoft, apple, whatever…..

  • Cullen Roche

    Lack of demand resulting in no need for capex. The ultimate cause of this is not a hoarding of cash. It’s households who don’t have enough cash to meet their de-leveraging needs.

  • Andreas Tirez

    So a Keynesian stimulus is the proper answer then?

  • Cullen Roche

    Depends on your definition of “proper”. The best policy stabilizes balance sheets. You could argue that QE1 helped do that to some degree due to the degree of panic, but has had lesser impacts as the economy has normalized. But fiscal policy is likely to help more because of the net asset add via bonds. Tax cuts or deficit spending achieves that.

  • Enn


    Quick question. If the bond vigilantes don’t control the bond market, what was responsible for the run up in rates in the 1970s?

  • Cullen Roche

    The Fed forecasting higher rates caused bond traders to front-run. In other words-the economy forces the Fed who forecasts to traders who ultimately set the price via front-running.

  • hangemhi

    Reading Krugman’s latest article makes me think he STILL doesn’t get it. He calls the bond vigilantes “invisible” not a “myth” or something/someone that doesn’t actually exist. He also refers to an incredibly loose non-defined “people” in this curious sentence that seems to belie Huh’s point: “it basically can’t experience an interest rate spike unless people see an increased chance of economic recovery…” Am I alone in seeing a serious conflict in Krugman’s view vs. Cullen’s? To me it appears “people” are bond vigilantes – because if it wasn’t, and he was referring to the Fed, wouldn’t he say the Fed?

    In sum, Krugman seems to believe bond vigilantes do exist, but are just “invisible” in our current environment. Until he comes out and flat out says: “there is no such thing as bond vigilantes in the US and similar monetary systems” than he is in conflict with Cullen’s view, and Cullen will be writing articles like this until that time.

  • PeterP

    Krugman post 2008 thought that yields cannot rise for the wrong reasons: ISLM told him we were in a liquidity trap, once we were out, could we become the next Greece? “Absolutely” wrote Krugman in an oped as recently as March 2011 (!). Now he claims this is not the case. It is fundamental.

  • Cullen Roche

    Hey Peter,

    Do you have a source on that “absolutely” comment? Thanks.

  • Android

    hear! hear!

  • Robert Laden

    The problem is that the article does describe the process as it is exists right now (and not as it might be). But the next posting down, correctly points out that the patient (the economy) requires larger and larger doses of the same old medicine just to keep it going. Stay tuned for how that gets resolved

  • Cowpoke

    EXACTLY. QE1 or at least QE1.5 should have been a FISCAL policy that totally eliminated the 13+% social security payroll tax for a year or two provided that people could itemize a debt reduction amount equal to the deduction claim.
    This would have been a MUCH better policy than giving folks a few hundred bucks to go spend at wally land.

  • Cowpoke

    Cullen, how can that be when the FED controls the rate?
    The FED should have eased monetary policy during the 70′s but instead tightened. This combined with the energy crisis/oil embargo’s caused rates to rise. (I Think)
    look at this chart from the FED, it only goes back to 1980 but It may make my point:

  • Geoff

    I also wonder if going off the gold standard caused some initial growing pains in the 70′s. Not to mention the fact that Volker decided to experiment by targeting quantity (money supply) rather than price, thus letting interest rates fly. I don’t see Bernanke, or his successor, making the same mistake.

  • PeterP

    It is “of course” instead of “absolutely”.

  • Cullen Roche

    Ah, thanks Peter. There’s the money quote:

    “But couldn’t America still end up like Greece? Yes, of course. If investors decide that we’re a banana republic whose politicians can’t or won’t come to grips with long-term problems, they will indeed stop buying our debt. But that’s not a prospect that hinges, one way or another, on whether we punish ourselves with short-run spending cuts.”

    – Krugman, NY Times, Austerity article

  • SS

    Krugman still doesn’t get it. He thinks bond vigilantes can still attack the USA.

  • Delta Financials

    The notion that inflation expectations have nothing to do with rates at the long-end is a little silly. There’s more than enough macro evidence to back that claim. Inflation ‘expectations’ being expectations can be flawed and there can be a subsequent repricing, but bond markets at the long end in issuer countries throughout the failed Keynesian 70s & 80s; and more recently in Brazil, India, etc (which did get a dose of inflation) re-iterate the fact that bond investors are primarily looking to preserve purchasing power. Give us a rational argument for future expansion, and we’ll run from the long-end. In fact, the varying spread between the long-end and short-end, in the absence of monetary signals from the central bank itself contradicts this version of how rates move.

  • Cy Hailow

    @ Cullen.

    Hi I’m with the others on this. Krugman has been ridiculing the invisible Bond vigilantes for a very long time(in the US). To focus on his thoughts on Japan vs Italy as a way refute this is to miss the point that he has been spot on re USTs and that’s the main game in town.

  • Hangemhi

    Cy, I think you’re missing the point – a broken clock can be right for the wrong reasons too. If he thinks bond vigilantes aren’t imminent (as evidenced by the above NYT quote) rather than non-existent he is ultimately wrong. To be sure we all see Krugman getting closer and closer to being right, and are rooting for that to happen, but right now he is still a broken clock on this issue.

  • bart


  • bart

    Krugman will never get it, he’s way too politically biased as well as way too worshipful of his very flawed understanding of basic econ.

  • Cullen Roche

    See this quote. Krugman’s never had this right. This quote displays a very specific misunderstanding of the monetary designs in the USA and Europe and it’s from 2011:

    “But couldn’t America still end up like Greece? Yes, of course. If investors decide that we’re a banana republic whose politicians can’t or won’t come to grips with long-term problems, they will indeed stop buying our debt. But that’s not a prospect that hinges, one way or another, on whether we punish ourselves with short-run spending cuts.”

    – Krugman, NY Times, Austerity article

  • Mr. Market

    The fact that DeLong & Krugman have capitulated to the notion that there’re no Bond Vigilantes, is for me an indication that we’re getting close to the very end of a 32 year period of falling interest rates.

  • JWG

    A thought experiment. If the Fed stopped buying MBS and Treasuries tomorrow, what would the interest rate reset be? Answer: the Fed cannot stop buying because the reset would be disastrous and so its balance sheet must grow indefinitely. At some point much of the Treasury’s debt to the Fed will simply be cancelled de facto if not de jure, because for the Fed to try to sell that debt into the market will be too destabilizing. There are no bond vigilantes, but if the Fed becomes the dominant market for Treasury debt in the long term, there will be no other market offer at anywhere near the rates the Fed wants to set. At that point, the rest of the world might question reserve currency status for the dollar; is there any alternative?

  • Cowpoke

    What interest rate are you refering to, the federal funds rate?

  • joe

    i guess i take issue with you cheekily saying the liquidity trap is wrong because liquidity has clearly been trapped for the last 4 years.

    firms that are financially healthy and can hire aren’t hiring, but instead are just sitting on cash. people that are financially stable and can borrow aren’t borrowing, so banks aren’t lending, but instead are just sitting on cash.

    the liquidity trap theory is just that the rate of interest that would establish full employment is negative, and so households and firms hoard cash instead of receiving a negative interest rate. liquidity is clearly trapped in the system because people who can spend and lend haven’t been doing it.

    i think at some point you assumes all private agents are unable to act because all are debt-ridden or whatever, but you don’t allow for the possibility of non-debt-ridden agents that aren’t spending or borrowing even though they have the ability to, which manifests itself most clearly in the cash balances of firms.